Sunday, July 19, 2009

Words of Wisdom On The Pursuit Of Holy Grail Investing

``Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn't the head, but the stomach that determines the fate of the stock-picker." - Peter Lynch

In stock markets, the implication that the public buys stocks because of entirely valuation purpose is a fallacy.

People buy or sell stocks for myriad of reasons, aside from valuations, namely, monetary policy induced responses (yield chasing), momentum, charting, punting or even to the most trivial reasons such as social pressures, gossip based or ‘my neighbor/TV/guru says so’ and etc.

Valuations, as presented by typical sell side institutions, frequently represents as fodder for cognitive biases for participants in search of a fillip or stimulant to take or justify actions (confirmation, available or information bias) or ownership (post purchase rationalization).

It’s almost commonplace to see people act (buy) supposedly based on “fundamentals” and act (sell) oppositely based on intuition. Time would, in essence, be the defining or distinguishing factor, as short term trades HARDLY REFLECT on the changes in the so called “micro” or “macro” fundamentals which are mostly long term driven.

Hence, rationalizations over the direction of actions don’t match and serve as concrete evidence of cognitive dissonance or disorientation on the part of the short term punter.

In an off track horse betting station, these would be the routine responses when a punter loses a bet… “I had that horse on my list, but”, “I was about to bet on that horse, but”, the “teller changed the number”, the “jockey took a dive!”, the “race was rigged!” and etc…

For the winner, I am GOOD!!!

This practically is a feel good thing or about self importance, more than risk-reward tradeoffs over the odds of the racing event as horse punters essentially disregard the cumulative effects (ratio of losses over wins) and look at day to day outcomes.

In behavioral finance lingo this is called fundamental attribution error or the attribution of success to oneself and failures to external or other sources.

The same errors can be observed with most market participants with short term expectations and perspectives.

And that’s why short term perspectives seem almost always in search of the ever elusive Holy Grail, because goals, required information, emotions of the moment and actions don’t square.

And Dr Janice Dorn, in her magnificent article Trading Lessons: There Is No Magic Bullet published at the minyanville.com, eloquently articulates on the psychological framework behind these (bold highlights mine),

``Most traders are looking for the Holy Grail, the keys to the kingdom, the one great book. They want the magic indicator, the chart pattern, thing, or person that will tell them what's going to happen, and what to do.

``It's a natural human tendency to want to know what's going to happen next. Chart patterns, indicators, fundamental analyses, or technical analyses are constructs we build in an attempt to bring order to uncertainty. We do this in part because we're afraid that, without a detailed roadmap, we may have no future.

``In the process of building these models, we become them. We want to believe what our eyes are seeing, when what we're really seeing are our own limitations. Charts are emotions plotted on a grid: When emotions change, the charts do, too. We can't control that, just as we can't control what others believe, or how they act on their beliefs.

``We can control only one thing: how we respond to the situation that's right in front of us. In order to do this with consistent success, we must adopt an attitude of flexibility, and rid ourselves of all our rigid assumptions.

``In the final analysis, those things we've seen on paper or had in our heads before we enter the markets are illusions. They may be useful illusions, but they're illusions nonetheless. We have no idea whether they're true or not until the markets tell us. If there's any absolute truth in trading, it's that, with 2 possible exceptions, the markets are always right. Traders ignore this at their own peril. If there's a technique for winning, it's to stop believing in so many things that are wrong. In order to do this, we must learn to harness the villains of pride and greed that speak falsely to us, telling us that we've already won. We haven't won if the markets say we've lost. By eliminating what's false, we open ourselves to the truth.”

In short, biases are illusions and pride and greed are obstruction to goals, which ultimately reveals that the basic problem, in the financial markets, is in dealing with the self. Ergo, any serious traders or investors would need to subdue or minimize these frailties and develop a strong sense of self discipline instead of looking for external attributions or excuses.

This goes similar to the prescriptions of Peter Lynch of the traits of a successful investor, ``The list of qualities [an investor ought to have] include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic.”

Since the world is highly complex, where we can’t discount the contribution of luck in any endeavor we opt to undertake, I’d like to add, the ability to harness and manage luck!


China In A Bubble, ASEAN Next Leg Up?

``The margin of safety is the central concept of investment. A true margin of safety is one that can be demonstrated by figures, by persuasive reasoning and by reference to a body of actual experience". Benjamin Graham

Recently I stumbled upon some quants predicting (ZeroHedge) a crash in China’s stock markets over the next few days.

Although there have been many doing so, what attracted my attention is that they had the temerity to quantify the period for the said event-particularly, July 17 to July 27.

This group seems to have a good track record of predicting events, in contrast to most of their genre (whom were caught with the recent market meltdown), albeit mostly way TOO early based on their site.

I have no idea whether these will occur or not, but I won’t bet on their side.

Although based on Figure 4 by US global Investors, China is clearly operating in bubble territory.


Figure 4: US Global Investors: Monetary Expansion in China

As caveat, bubbles normally take time to reach a climax. For instance, the US real estate bubble ballooned from 2002-2006, while global stock markets inflated from 2003-2007. True, today’s China bubble could risk being pricked hastily or abruptly, but in my view, this may seem too early.

It’s because normal bubble cycles need sustained massive infusions (we seem to be seeing the first phase) and the vast concentrations or clustering of resource misallocations that could either become huge enough to be extremely sensitive to interest rate hikes or would require continued exponential amplification of credit to maintain present price levels or a pyramiding dynamics…until the structure in itself can’t be sustained (usually interest rates from market or policy induced does the trick).

I doubt if we have reached that point.

Besides, I think that the risks seem more tilted towards government debt bubbles as global governments appear predisposed to activating money printing solutions at any signs of renewed weakness or distress in their respective domestic economies.

Remember, the present environment, for the officialdom, is construed as signs of policy based accomplishments, hence, more of the same treatment will likely be applied but at higher dosages, if asset (stock) markets fall.

Unfortunately, such policies seem to direct people into speculating more than investing.

Global policymakers, as we have reiteratively been asserting, appear to target the stock markets as the preferred signaling channel to communicate “recovery” to the public.

Figure 5: US Global Funds: Strong Loan Growth in China

And global central banks appear willing to inflate more by maintaining loose money policies to encourage bank lending growth, rather than to tighten in order to support sentiment (albeit mostly speculative) or the “animal spirits”.

In the case of China (see figure 5), the surge in loan growth appears to have triggered some alarm bells in the officialdom, as the People’s Bank of China (PBoC) had reportedly been mulling to “switch to more direct lending controls” to temper growth and where recent sales of Chinese Treasury bills saw the government accepting higher rates (Forbes). Given ample evidences of sustained economic growth, it is believed that China would begin to increase interest rates by 2010 (Bloomberg).

Hence we see the odds seem likely for a correction from severely overbought levels than from a prospect of a crash as foreseen by the quants.

However, Chinese policymakers, like their US counterparts seem to be increasingly in a bind. An early tightening (increase rates or bank reserves) or if the market sees the need for higher rates, could set off renewed volatility hence, the likelihood for both the governments to press for asset friendly bubble blowing policies.

Figure 6: Russia’s RTSI: A Probable Path For China’s SSEC

Nonetheless, in figure 6, China’s (black) trajectory could probably follow Russia (black red), where the latter saw its stock benchmark fell by 80% during the recent crisis and rebounded by 129% and has corrected by 29% at its most recent trough and appears to be on a path to recovery.

Since March of this year, China’s Shanghai Index has shown no pause from its winning streak- a valid cause of concern.

For the meantime, financial systems that have been less leveraged than their counterparts in the developed countries seem likely to absorb more of the inflationary policies adopted by their national governments and or transmitted by the US Federal Reserve.

Last week, perhaps due to this, several Asian bellwethers either broke their resistance levels or are adrift at these levels attempting for a breakout see figure 7.

Figure 7: Stockcharts.com: ASEAN Bourses

So far only Malaysia (MYDOW) has successfully cleared the hurdle while Singapore (STI), Korea (KOSPI) and Indonesia (IDDOW) are almost over the threshold point.

Meanwhile other bourses such as Taiwan, Hong Kong and Pakistan are likewise approaching their respective resistance levels with a probable test to break these barriers soon. Next week perhaps?

From where we stand, momentum appears to tell us that the next leg could likely be up for most of Asian bourses mostly led by ASEAN bellwethers.

And this should include the Philippine Phisix.


Example Of Chart Pattern Failure

As we always say chart patterns can’t be relied upon for that pivotal decision, most especially the short term ones.


The May-July S&P 500 Head and Shoulders pattern (blue curves) which had been used by the bears to call for a market crash appears to have been invalidated.

However, there is another longer term reverse Head and Shoulders (red curves) from which a break off the 950 neckline level would suggest of a vital upward thrust. Technically a break from the 950 should lead towards the 1,234 target. I doubt this to occur unless governments inflate extensively anew (second round stimulus?).

I have no opinion on where the US markets will be headed over the short or medium term. Although given the inflationary tendencies of the US government, it may seem that the recent lows could have likely served as the bottom or the floor, unless proven otherwise. But we're not saying its gonna be a bull market too.

Remember, inflation as a component of US equity returns, [see last week’s Worth Doing: Inflation Analytics Over Traditional Fundamentalism!] are likely to grow at a much faster clip than dividends or real capital returns.

And the US government has been practically inflating to support asset (stock and real estate) prices.

Saturday, July 18, 2009

Big Mac Index Update: Asia Cheapest, Europe Priciest

The Economist has recently released its Big Mac Index as a guide to valuing currencies based on purchasing power parity.

Basically, the idea is, leveraging from McDonald's global presence and its best selling product Big Mac and its worldwide reach to consumers, the Economist uses the Big Mac as a benchmark to estimate on the worth of national currencies compared to the US dollar-since the US dollar has functioned as the world's international currency standard.

According to the Economist, ``WHICH countries has the foreign-exchange market blessed with a cheap exchange rate, and which has it burdened with an expensive one? The Economist's Big Mac index, a lighthearted guide to valuing currencies, provides some clues. The index is based on the idea of purchasing-power parity (PPP), which says currencies should trade at the rate that makes the price of goods the same in each country. So if the price of a Big Mac translated into dollars is above $3.57, its cost in America, the currency is dear; if it is below that benchmark, it is cheap. A Big Mac in China is half the cost of one in America, and other Asian currencies look similarly undervalued. At the other end of the scale, many European currencies look uncompetitive. But the British pound, which was more than 25% overvalued a year ago, is now near fair value." (emphasis mine)

Why Purchasing power parity (PPP) as the selected gauge?

Perhaps using the wikipedia.org explanation, `` Using a PPP basis is arguably more useful when comparing differences in living standards on the whole between nations because PPP takes into account the relative cost of living and the inflation rates of different countries, rather than just a nominal gross domestic product (GDP) comparison." (bold highlight mine)

Of course, PPP is simply a statistical construct that doesn't take into the account the capital structure or the operating framework of the political economies of every nation, which is impossible to qualify and or quantify.

Left to its own devices, theoretically, the currency markets should have closed such discrepancies. But again, national idiosyncrasies and much government intervention to maintain certain levels in the marketplace, as policy regimes embraced by many countries with a managed float or fixed/pegged structure, hasn't allowed markets to work in such direction.

Nonetheless, present trends indicate of a growing chasm in the currency values (based on PPP) where continental Europe has been getting pricier while Asia has been getting cheaper.

As per July 13th based on the currencies monitored by the Economist, Hong Kong is the cheapest currency against the US dollar (-52%) , followed by China, Sri Lanka, Ukraine (-49%), Malaysia, Thailand (-47%), Russia, Indonesia (-43%) and the Philippines (-42%) using the % variance against the US dollar from where the abovementioned currencies are 40%+ below.

Based on the Big Mac Index alone, it would appear that Asia's currencies have much room to appreciate against the most expensive Euro or against the US dollar.

Thursday, July 16, 2009

Despite Lesser Wealth, Philanthropic Activities Grows

In an environment where the world's richest have become materially less richer...

This from the Economist, ``THE wealth of the world’s richest people fell by almost a fifth last year to $33 trillion, according to the World Wealth Report from Merrill Lynch and Capgemini. A rich person is defined as having at least $1m of assets besides his main home, its contents and collectable items. The number of rich people shrank by 15% to 8.6m, or 0.1% of the world's population. Their wealth declined by more than 20% in North America, Europe and Asia, but by a bit less in Africa and the Middle East. Latin America’s rich were the least affected: they lost 6% of their wealth, and the number there fell by less than 1%. In North America, which had a large proportion of people just above the $1m threshold, the ranks slimmed by 19%." (emphasis added

Growth in philanthropic activities remain less affected...

According to the Economist, ``THE global recession has failed to dampen philanthropic spirit, with many rich people increasing their charitable giving, according to a new report from Barclays Wealth. Among the 500 British and American individuals with at least $1m of investable assets, only education was considered a more important expense than charitable commitments. Some 28% of Americans say they are giving less money compared with 18 months ago, though 26% are giving more. A similar pattern is seen among those givers from both countries who inherited their fortune. But entrepreneurs are more likely to give their cash away—31% say they have increased their giving and only 17% have reduced it."

The spirit of charity doesn't vanish along with the crisis. On this account, it even increases them.

Wednesday, July 15, 2009

Global CDS Markets: Goldilocks Is Back?

Is the world headed for Inflation or Deflation?

From the Credit Default Swap (CDS) market perspective…

NEITHER.

Instead, it has been a GOLDILOCKS time, as the cost of insuring debt has materially declined for most of the world except Japan, Israel and Iceland!

Markets have been pricing in reduced risks of sovereign credit defaults despite massive stimulus expenditures engaged by global governments as shown by the updated table of CDS standing by Bespoke.


Chart from Bespoke

And the best performers have been emerging markets.

This from Bespoke Invest, `Russia and China are in the top five of countries that have seen default risk decline the most. Germany and France haven't seen their default risk decline by much, but it also didn't rise nearly as much as other countries during the height of the crisis. Germany, France, and the US have the lowest default risk in the world.”

The Philippine sovereign has been ranked 13th among the best performers. No wonder the huge demand on its recent offering.

Well it is likely that this has been a short-term honeymoon, as the US Federal deficits have now exceeded US $1,000,000,000 9 months into the fiscal year.



And this seems more likely to be the proverbial calm before the storm.

Phisix 10,000:Clues From Philippine Bond Offering

When we talk about investing, it is universally about the expectations of the shifting balances of demand and supply in specific markets.

And the recent issuance of the Philippine bonds should give us a clue.


Here is an excerpt (bold emphasis mine)


``At the time of pricing, the yield resulted in a spread of 332.6bp over the 10-year US Treasury maturing in May 2019. This marked a sharp tightening versus the 599.9bp spread that was required when the Republic of thePhilippines sold $1.5 billion of 10-year bonds due in June 2019 in January this year and shows how much the market has improved since then. The yield on the 2019 bonds has dropped to about 6.4% now from 8.5% at the time they were issued.


``Even more impressively though, sources said the new bonds priced right in line with the implied Philippines curve as interpolated from the yield levels of the Philippines 2019s and 2024s. In other words, investors received no new issue premium at all.


``Not that this seemed to worry them. The offering attracted $4.4 billion worth of demand split on 202 orders, even though the term sheet clearly stated that the $750 million deal size would not be increased. As usual for Philippine issues (this is after all the country that "gave a name to the Asian bid", as noted by one analyst), a large chunk of that demand came from domestic investors, and in the end, 40% of the deal was allocated to Philippine accounts. Investors based in the rest of Asia took another 20%, while 25% went to the US and 15% toEurope.


``In terms of investor type, funds took 50%, banks 39% and retail investors 6%. The remaining 5% went to insurance companies and "others".


Some notes:


-Tightening spreads means greater demand for local debt over US treasuries.


-Investors received no premium yet the offering had been oversubscribed.


-Locals commanded the bulk 40% of the financing, which demonstrates of the immense liquidity (source of financing) of the system.


In a world of Zero Bound Policy, where yields (Peso and US dollar) on fixed income has been going down and the US dollar-Philippine Peso trades in a tight range-essentially narrows the choices for local institutions and investors as to where they should allocate savings.


And the above conditions which is an unambiguous manifestation of the loose monetary landscape is essentially shaping an environment for greater yield searching dynamics backed by a prospective expansion of credit from a system that has been largely underleveraged.


This shifts the risk premium from financial markets to real business investing.


All said, you are looking at a prospective boom (bubble) in the local equity market!


Phisix 10,000, anyone?

Monday, July 13, 2009

Has Lack Of Regulation Caused This Crisis? Evidence Says No

We find it odd when experts argue of the lack of regulation as the cause of this crisis.

Evidence simply don't support such claims...

Chart From Casey Research

According to Casey Research, ``The Federal Register is a daily publication of all the proposed and final rules and regulations of the U.S. government. The size of the register is often used to gauge the scope of regulation, and it’s been on steroids for decades.

``According to the Washington, DC-based Competitive Enterprise Institute’s 2009 edition of “Ten Thousand Commandments” by Clyde Crews, the cost of abiding federal regulations is estimated at $1.172 trillion in 2008 – 8% of the year’s GDP. This “regulation without representation,” says Crews, enables the funding of new federal initiatives through the compliance costs of expanded regulations, rather than hiking taxes or expanding the deficit."

Imagine, compliance costs at an estimated 8% of the GDP and growing!!! This represents as tremendous burden, since it reduces the productive capacity of the US economy. Money that would have gone into capital investments have been lost due to sheer compliance on the massive regulatory structure.

To add, the Federal Tax Code (see below) which is also incorporated in the Federal Register has also seen a ballooning of pages-67,506.

The tax code had only 400 pages in its inception in 1913!

More from George Reisman [The Myth That Laissez Faire Is Responsible For Our Crisis] (bold highlights mine)
  1. Government spending in the United States currently equals more than forty percent of national income, i.e., the sum of all wages and salaries and profits and interest earned in the country. This is without counting any of the massive off-budget spending such as that on account of the government enterprises Fannie Mae and Freddie Mac. Nor does it count any of the recent spending on assorted "bailouts." What this means is that substantially more than forty dollars of every one hundred dollars of output are appropriated by the government against the will of the individual citizens who produce that output. The money and the goods involved are turned over to the government only because the individual citizens wish to stay out of jail. Their freedom to dispose of their own incomes and output is thus violated on a colossal scale. In contrast, under laissez-faire capitalism, government spending would be on such a modest scale that a mere revenue tariff might be sufficient to support it. The corporate and individual income taxes, inheritance and capital gains taxes, and social security and Medicare taxes would not exist.

  2. There are presently fifteen federal cabinet departments, nine of which exist for the very purpose of respectively interfering with housing, transportation, healthcare, education, energy, mining, agriculture, labor, and commerce, and virtually all of which nowadays routinely ride roughshod over one or more important aspects of the economic freedom of the individual. Under laissez-faire capitalism, eleven of the fifteen cabinet departments would cease to exist and only the departments of justice, defense, state, and treasury would remain. Within those departments, moreover, further reductions would be made, such as the abolition of the IRS in the Treasury Department and the Antitrust Division in the Department of Justice.

  3. The economic interference of today's cabinet departments is reinforced and amplified by more than one hundred federal agencies and commissions, the most well known of which include, besides the IRS, the FRB and FDIC, the FBI and CIA, the EPA, FDA, SEC, CFTC, NLRB, FTC, FCC, FERC, FEMA, FAA, CAA, INS, OHSA, CPSC, NHTSA, EEOC, BATF, DEA, NIH, and NASA. Under laissez-faire capitalism, all such agencies and commissions would be done away with, with the exception of the FBI, which would be reduced to the legitimate functions of counterespionage and combating crimes against person or property that take place across state lines.

  4. To complete this catalog of government interference and its trampling of any vestige of laissez faire, as of the end of 2007, the last full year for which data are available, the Federal Register contained fully seventy-three thousand pages of detailed government regulations. This is an increase of more than ten thousand pages since 1978, the very years during which our system, according to one of The New York Times articles quoted above, has been "tilted in favor of business deregulation and against new rules." Under laissez-faire capitalism, there would be no Federal Register. The activities of the remaining government departments and their subdivisions would be controlled exclusively by duly enacted legislation, not the rule-making of unelected government officials.

  5. And, of course, to all of this must be added the further massive apparatus of laws, departments, agencies, and regulations at the state and local level. Under laissez-faire capitalism, these too for the most part would be completely abolished and what remained would reflect the same kind of radical reductions in the size and scope of government activity as those carried out on the federal level.

It's incredible to discover how the gullible public falls for such deceptions.

Emerging Markets Stocks Outperform: Signs Of A Top Or Of A New Dynamic?

Bloomberg's chart of the day shows how emerging markets have recently been outperforming the US S&P 500 in terms of weekly PE ratio.

Some notes from the article (all bold emphasis mine) including my comments in captions

-The MSCI emerging-market index had 13 bull-market rallies of at least 20 percent and 12 bear-market declines of the same magnitude since its inception in December 1987, according to data compiled by Birinyi Associates Inc., the Westport, Connecticut-based research and money management firm founded by Laszlo Birinyi. That compares with five bull markets and four bear markets for the S&P 500 during the same period.

(This implies that Emerging Markets stocks are more volatile than the developed market peers)

-The increase cut the dividend yield of the emerging-market gauge to 3 percent, compared with 3.5 percent for developed countries. MSCI’s emerging-market index fetches 1 times sales and 6.6 times cash flow, compared with 0.8 and 4.3 in the advanced gauge, data compiled by Bloomberg show.

(based financial ratios EM stocks seem more expensive, but financials don't tell the entire story)

-Developing nations’ share of global equity value climbed to an all-time high this month as investors poured in a record $26.5 billion last quarter, according to data compiled by Bloomberg and EPFR.

-The Washington-based IMF estimates developing economies will grow 1.5 percent as a group this year and 4.7 percent in 2010, while advanced economies will contract 3.8 percent in 2009 and expand 0.6 percent next year.

(And it won't be entirely a story of economic growth too)

-Developing nations traded at a discount to American equities from 2001 to 2006 even after their economies expanded at almost three times the pace, according to Bloomberg and IMF data. They moved to a premium in October 2007, the peak of a five-year advance that sent the MSCI gauge up fivefold. The index’s drop in 2008 was almost 16 percentage points steeper than the S&P 500’s 38 percent slide, the worst since 1937.

(the article suggests that when EM stocks outperform, a reversal looms)

-When emerging-market valuations climbed above the U.S. in 1999 and 2000, it foreshadowed the end of a seven-year global rally. The MSCI developing-nation index sank 37 percent in the 12 months after March 2000, compared with a 23 percent slide in the S&P 500.

(same argument here)

-Companies in the MSCI emerging-markets index that reported results since the end of the first quarter posted an average earnings drop of 92 percent, trailing analysts’ estimates by 14 percent, according to Bloomberg data. That compares with a 46 percent profit slide for Europe’s Dow Jones Stoxx 600 Index and a 31 percent fall for the S&P 500, Bloomberg data show.

Additional comments:

The general disposition of the article is one of negativity. It implies that EM stocks outperforming developed economy stocks seems like an anomaly and isn't destined to happen for long.

Not only that, such aberration in the past has signaled a reversal of global stock markets.

Looking at history to make comparisons, when present dynamics aren't the same seems either like anchoring or reductionism (oversimplification of causality).

While it is true that we seem to be seeing some weaknesses in global markets of late, it isn't certain that all global markets will behave similarly like in 2008 or in 2000. The article discounts the possibility of divergences, a phenomenon we think will manifest itself overtime.

Growth or financial ratios won't be the only issues that needs to be reckoned with, but more importantly for us, is the impact from concerted and coordinated policies by global governments on national markets and economy.

This is because every country has a distinct political economic structure that we assume would respond differently to such policies. And the diverse responses will likely be manifested on the asset market pricing.

Sunday, July 12, 2009

Worth Doing: Inflation Analytics Over Traditional Fundamentalism!

``Economics is not about goods and services; it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium. These constructions are only tools of reasoning. The sole task of economics is analysis of the actions of men, is the analysis of processes.”- Ludwig von Mises Logical Catallactics Versus Mathematical Catallactics, Chapter 16 of Human Action

Marketing guru Seth Godin has this fantastic advice on quality,

``When we talk about quality, it's easy to get confused.

``That's because there are two kinds of quality being discussed. The most common way it's talked about in business is "meeting specifications." An item has quality if it's built the way it was designed to be built.

``There's another sort of quality, though. This is the quality of, "is it worth doing?". The quality of specialness and humanity, of passion and remarkability.

``Hence the conflict. The first sort of quality is easy to mandate, reasonably easy to scale and it fits into a spreadsheet very nicely. I wonder if we're getting past that.

In essence, everything we do accounts for a tradeoff. When we make choices it’s always a measure of acting on values.

For instance, the “quality” of providing investment advisory is likewise a tradeoff. It’s a compromise between the interests of investors relative to the writer and or the publisher. It’s a choice on the analytical processes utilized to prove or disprove a subject. It’s a preference over the time horizon on the account of the investment theme/s covered. And it’s also a partiality on the recommendations derived from such investigations.

So “meeting specifications” which is the conventional sell side paradigm has mainly the following characteristics, it is:

-short term oriented (emphasis on momentum or technical approaches),

-frames studies based on “spreadsheet variety” (reduces financial analysis to historical performance than to address forward dynamics),

-serves to entertain more than to advance strategic thinking,

- promotes heuristics or cognitive biases

-upholds the reductionist perspective or the oversimplified depiction of how capital markets work and

-benefits the publisher more than the client (Agency Problem)

Yet many don’t realize this simply because this has been deeply ingrained into our mental faculties by self serving institutions that dominate the industry.

And instead of merely meeting the specifications which is the norm, here we offer the alternative-the “is it worth doing?” perspective.

Why?

-Because we realize that successful investing comes with the application of the series of "right" actions based on the “right” wisdom and rigorous discipline.

And with “right” wisdom comes the broader understanding of the seen and unseen effects of government policies that IMPACT asset markets or the economy more than just the simplistic observation that markets operate like an ordinary machine with quantified variables.

-Because government policies shape bubble cycles which underpins the performance of asset prices.

Think of it, if markets operate unambiguously on the platform of “valuations” or the assumption of the prevalence of rational based markets, then bubble cycles won’t exist.

Hence, the failure to understand policy directions or policy implications would be the Achilles Heels of any market participant aspiring success in this endeavor.

For instance, with nearly 90% of oil reserves or supplies under government or state owned institutions, any analysis of oil pricing dynamics predicated on sheer demand and supply without the inclusion of policy and political trends would be a serious folly or a severe misdiagnosis.

Of course, money printing by global central banks adds to the demand side of the oil equation. Moreover, price control policies can be an interim variable. The recent attempt to curb speculative trading in oil can be construed as a significant factor for the recent oil collapse in oil prices.

-And also because I try to keep in mind and heart Frederic Bastiat’s operating principle, ``Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.”

In short, the seen and unseen effects of policy actions and political trends are the operating dynamics from which underlines our “is it worth doing?” perspective.

Financial Markets As Fingerprints

We have repeatedly argued against the mainstream and conventional view that micro fundamentals drives the markets [see Are Stock Market Prices Driven By Earnings or Inflation?].

Stock markets, for us, have been driven by principally monetary inflation, and secondarily from sentiment induced by such inflation dynamics. All the rest of the attendant stories (mergers, buyouts, fundamentals such as financial ratio, etc…) function merely as rationalizations that feeds on the public’s predominant dependence on heuristics as basis of decisions in a loose money landscape.

In an environment where liquidity is constrained, no stories or financial strength have escaped the wrath of the downside reratings pressure.

The disconnect between market price actions over the performance of corporate financials or the domestic economy have been conspicuous enough during the last bull (2003-2007) and bear cycles (2007-2008) to prove our assertion.

Moreover, up to this point our skeptics haven’t produced any strong evidence to refute our arguments. Instead we had been given a runaround, alluding to some regional securities as possible proof of exemptions.

Here we discovered that inflation and inflation driven sentiment seem to apply significantly even in the more sophisticated markets of Asia as well.

So, instead of weakening our arguments, the wider perspective has even reinforced it.

Moreover, financial markets shouldn’t be seen as operating in uniform conditions. Such reductionist view risks glossing over the genuine internal mechanisms driving the markets. The underlying structure of every national financial markets appear like fingerprints-they are unique.

For instance, they have different degrees of depth relative to the national economy as seen in Figure 1.


Figure 1: McKinsey Quarterly Mapping Global Capital Markets Fifth Annual

The McKinsey Quarterly map reveals of the extent of distinction of financial market depth across the world. Yet growth dynamics are underpinned by idiosyncratic national traits.

So it would be an “apples to oranges” fallacy to take the Philippines as an example to compare with the US markets or other markets in trying to ascertain the degree of “fundamentals” affecting price actions versus the inflation perspective.

Finding scant evidence that the Philippine market is driven by fundamentals, we’ll move to ascertain the impact of inflation to US markets-the bedrock of the capital markets.

The US has deeper and more sophisticated markets, where [as we pointed out in PSE: The Handicaps Of A One Directional Reward Based Platform] investors can be exposed to profit from opportunities in all market directions- up, down and consolidation, given the wide array of instruments to choose from, such as the Exchange Traded Funds, Options, Derivatives and other forms of securitization vehicles.

This leads to more pricing efficiency in relative and absolute terms.

This also implies that deeper and more efficient markets tend to be more complicated. Nonetheless this doesn't discount policy induced liquidity as a significant variable affecting asset pricing.

In lesser efficient markets as the Philippines or in many emerging markets, the lesser the sophistication and the insufficient depth accentuates the liquidity issue.

The fact that the broad based global meltdown in 2008 converged with almost all asset markets except the US dollar, had been a reflection of liquidity constraints as a pivotal factor among other variables.

S&P 500 Total Nominal Return Highlights Rapid Inflation Growth!

Since we don’t indulge in Ipse Dixitism, the proof in the pudding, for us, is always in the eating.


Figure 2: Investment Postcards: Components of Equity Returns

This excellent chart from Prieur Du Plessis’ Investment Postcards (see figure 2) showcases the categorized return of equity capital since 1871. That’s 138 years of history!

Says Mr. Plessis, ``Let’s go back to the total nominal return of 8.7% per annum and analyze its components. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.8% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!”

While it is true that dividends accounted for as the biggest growth factor in equity returns in the S&P 500 benchmark yet, where inflation so far has constituted about 25.3% (2.2%/8.7%) of total returns, what has been neglected is that rate of growth of inflation has far outpaced the growth clip of both capital and dividend growth.

Notice that inflation had been a factor only since the US Federal Reserve was born in 1913. Prior to 1913, equity returns had been purely dividends and capital growth.

And further notice that the share of inflation relative to total returns has rapidly accelerated since President Nixon ended the Bretton Woods standard by closing the gold window in August 1971 otherwise known as the Nixon Shock.

To add, the share of inflation has virtually eclipsed the growth in real capital!!!

In other words, investing paradigms predicated on the pre-inflation to moderate inflation era will unlikely work in an environment where inflation grows faster than dividends or capital.

Hence it is a folly to latch on to the beliefs of “fundamental driven” prices without the inclusion of policy induced inflation in the context of asset pricing.

This is a solid case where past performances don’t guarantee future outcomes!

To further add, if inflation has a growing material impact to the pricing of US equity securities, then the degree of correlation with the rest of the global markets must be significantly greater under the premise of market pricing efficiency.

Policy Induced Volatilities Against Mainstream Fundamentalism

Here is more feasting on the pudding (this should make me obese).


Figure 3: Hussman Funds Secular Bear Markets And The Volatility Of Inflation

Another outstanding chart, see figure 3, this time from William Hester of Hussman Funds.

Mr. Hester uses the volatility of inflation as a proxy for economic volatility.

In the chart, low inflation volatility extrapolates to higher price P/E multiples and vice versa.

Here it is clearly evident that when volatility is low, bubble valuations emerge (left window), whereas the regression to the mean from excessive valuations occurs when volatility of inflation or economic volatility is high (right window).

Mr. Hester adds, ``It's not only the level of volatility and uncertainty in the economy that matters to investors, but also the trend and the persistence in this uncertainty. Shrinking amounts of volatility in the economy creates an environment where investors are willing to pay higher and higher multiples for stocks, while growing uncertainty brings lower and lower multiples.” (bold highlight mine)

So, it isn’t just economic volatility (as signified by inflation) but uncertainty as a major contributory factor to the gyrations of price earning multiples.

And where does “uncertainty” emanate from?

It is rooted mostly from government intervention or political policies instituted by governments, such as protectionism, subsidies, higher taxes et. al.. or any policies that fosters “regime uncertainty” or ``pervasive uncertainty about the property-rights regime -- about what private owners can reliably expect the government to do in its actions that affect private owners' ability to control the use of their property, to reap the income it yields, and to transfer it to others on voluntarily acceptable terms” as defined by Professor Robert Higgs.

In actuality, Mr. Hester’s technical observations of the proximate correlations of inflation and price/earnings multiples is a reflection or a symptom of the operational phases of the business cycles.

As depicted by Hans F. Sennholz in the The Great Depression, ``Like the business cycles that had plagued the American economy in 1819–1820, 1839–1843, 1857–1860, 1873–1878, 1893–1897, and 1920–1921. In each case, government had generated a boom through easy money and credit, which was soon followed by the inevitable bust. The spectacular crash of 1929 followed five years of reckless credit expansion by the Federal Reserve System under the Coolidge administration.” (bold highlights mine)

So it would be plain shortsightedness for any serious market participants to blindly read historical “fundamental” performances and project these into future prices while discounting political or policy dimensions into asset pricing.

As we noted in last week’s Inflation Is The Global Political Choice, the financial and economic milieu has been hastily evolving post crash and is likely being dynamically reconfigured from where asset pricing will likewise reflect on such unfolding dynamics, ``the unfolding accounts of deglobalization amidst a reconfiguration of global trade, labor and capital flow dynamics, which used to be engineered around the US consumer, will likely be reinforced by an increasing trend of reregulations which may lead to creeping protectionism and reduced competition and where higher taxes may reduce productivity and effectively raise national cost structures, as discussed in Will Deglobalization Lead To Decoupling?

Hence, any purported objectives to attain ALPHA without the context of the measurable impact from policy or political dimensions over the long term are inconsistent with the intended goals.

Instead, these signify as lamentable and plaintive quest for short term HOLY Grail pursuits which is not attributable to investing but to speculative punts.

Hence, traditional “fundamentalism” serves as nothing more than the search for rationalizations or excuses that would conform to cognitive biased based risk taking decisions.

It’s not objectivity, but heuristics (mental shortcuts or cognitive biases) which demands for traditional fundamentalism metrics since evolving market and economic realities and expectations don’t match.

Under A New Normal, Old Habits Die Hard

London School of Economics Professor Willem Buiter [in Can the US economy afford a Keynesian stimulus?] makes the same policy based analysis when he predicts that the US will prospectively underperform the global markets due to the political direction,

``There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard.” (bold highlights mine)

Indeed, old habits, mainstream but antiquated beliefs are even more difficult to eliminate.


Figure 4: John Maudlin/Safehaven.com: Buddy, Can You Spare $5 Trillion?

In an environment where the dearth of capital will be overwhelmed by the expansive liabilities of global governments deficit spending policies [see figure 4], the underlying policy trends will determine, to a large extent, the dimensions of asset pricing dynamics.

And as we noted last week, deficits won’t be the key issue but the financing. Here a myriad of variables will likely come into play, ``the crux of the matter is that the financing aspect of the deficits is more important than the deficit itself. And here savings rate, foreign exchange reserves, economic growth, tax revenues, financial intermediation, regulatory framework, economic freedom, cost of doing business, inflation rates, demographic trends and portfolio flows will all come into play. So any experts making projections based on the issue of deficits alone, without the context of scale and source of financing, is likely misreading the entire picture.”

Yet, like us, PIMCO’s Bill Gross in his June Outlook sees a “New Normal” environment where investing strategies will have to be reshaped.

``It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.” (bold highlights mine)

So yes, ALPHA can only be achieved with respect to the understanding of the scope and scale of policy and political trends and its implication to the sundry financial assets and to the global and local economy as well as to industries. For instance, industries that have endured or will see expanded presence of the visible hand of governments will have systemic distortions that may nurture bubble like features of expanded volatility or could see underperformance over the long run.

And any models or assumptions built around traditional metrics are likely to be rendered less effective than one which incorporates political and policy based analysis.

In short, like it or not, in the environment of the New Normal, government inflation dynamics will function as the zeitgeist which determines financial asset pricing trends.

This brings us back to the issue of quality. For us, in almost every sense, it appears that the "is it worth doing?" perspective is the more profitable approach than simply abiding by the conventional “meeting specifications”.

Nonetheless for those who can’t rid themselves of such archaic habits, we suggest for them to enroll in local stock market forums where traditional fundamental information from diverse sellside sources or even rumor based information can possibly be obtained for free! Forums are recommended sources of information for short term players seeking market adrenalin and excitement.