Ignoring Black Swans and Market Cycles

``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability." Nassim Nicholas Taleb

I find it odd when local authorities come to defend the market as if they can actually move or change the direction of the markets or reverse a cycle on their sheer pronouncements.

In response to the market’s carnage, I read a government official saying that the selloff was an “overreaction” and “did not reflect the fundamentals”. How I wish they were singing the same tune in 2002.

In another article, a press conference of key market participants were quick to point out that low interest rates, cheap valuations, the country’s improving fiscal position, sanguine economic and corporate prospects plus slew of IPOs and buzzing corporate activities as potential catalyst to the market’s rebound.

Yet unknown to many, most of the grounds cited have been based on recent actions. Yes, present conditions have been extrapolated to project future outcomes, in the face of a “shock”. By shock I mean the unexpected contagion effect experienced our financial markets last week.

Take for example low interest rates and inflation; the deluge of money flows from remittances and portfolio and direct investments have been mainly responsible for these.

Portfolio investment at the margins as I have interminably argued has driven the Peso to record highs.

And the global phenomenon of money chasing for expanded yields have caused Philippine bonds to rally vigorously whose spreads with US treasuries have been at record lows. These essentially constitute the key factors that have brought down interest rates, aside from the appreciating Peso which has contributed to the decline of consumer “inflation” rates.

In addition, in the corporate field, 14 companies are lined up for this year’s scheduled IPOs while corporate activities have been abuzz, mostly because of the impressive performance of the Phisix as well as the market’s warm reception to the most recent IPOs.

Now think of what happens if portfolio flows reverse? The Peso will decline which should lead to higher interest rates and rising pressure on the consumer “price” inflation front.

If the Phisix continues to drop then many of these corporate activities could be deferred or shelved until a better time, and so as with the other corporate activities.

In other words, the scenario painted our experts will radically change. Yet, it is a public spectacle to see them use past performance in order to defend present conditions in the face of an unexpected or random events. They appear like political demagogues campaigning in today’s election season.

You have to understand that market cycles are simply an outcome of psychological transformations. First there is the “shock” or disbelief phase, then the denial phase and finally the capitulation phase.

In 2002, no one wanted to touch the market simply because it had been agonizingly in decline for several years. It marked the capitulation for the bulls which signified the start of the cyclical reversal.

In 2003, the market began its upside cycle as foreign money drove the index higher. Political jitters, which in the past comprised as a major hurdle, were simply ignored by foreign capital which continued to pile on our asset markets. Yet, many local investors remain in denial over this period.

And as the trend gets more entrenched and under the backdrop of the steep advances of 2006-7, many local investors succumbed to the rising tide, and commenced upon entering the market, in view that the prevailing trend will last.

Today, the chorus is that the Philippines is on a mend, viewed under the premises of the rising asset class, and as such declare the continuity of the present micro trends. Slowly but surely we seem to be entering the next phase of the cycle; bearish capitulation.

Most, however, continue to ignore the fact that macro drivers have been responsible for these advances, and when the macro factors turns against us, you’d likely see an interim reversal of the present activities. Last week appears to be our proof; the market and the Peso tumbled significantly.

Yet the macro developments could also be a function of the transitional cyclical phases of the world markets, where big price fluctuations are a natural phenomenon.

In a study by MIT economists, evidences has been produced that such outcomes have been periodical. According to analyst Mark Hulbert (emphasis mine), ``Their study, published several years ago in the prestigious scientific journal Nature, reports that large daily fluctuations in the stock market occur, on average, at very predictable frequencies. Instead of seeing these fluctuations as abnormal, the academics' theory suggests we see them as inherent features of the stock market's volatility.

``The study's authors derive a complex model that predicts how often declines of Tuesday's magnitude -- 3.3% in the Dow industrials -- will occur. Over many years, according to that theory, they should occur an average of every five to six months.”

Yes, the recent market action appears to be INITIALLY a cyclical behavior in response to an overheated market worldwide, since trends don’t move in linear fashion.

As I wrote a favorite client, ``But who would accept such explanation? Would you? There has always to be some reason/s. And that is where media loves to feed on...simplistic thinking; which will be what most of the investing public would be willing to digest, including your favorite sources of information.”

In a similar tone I found this very noteworthy quote from the Mr. Black Swan himself Mr. Nassim Nicholas Taleb from his soon-to-be-published book The Black Swan: The Impact of the Highly Improbable, ``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability."

Until we see further evidences that support the recent declines as fundamental [macro] based then it would best to treat today’s retreat as simply “inherent features of stock market’s volatility” or cyclical phases of markets.

Lastly, avoid from accepting pabulums premised on past performances, because as the markets have shown last week, Black Swans exists!