Our Phisix Outlook: From Bullish to Neutral

``Faced with the challenges of managing policy in an increasingly integrated world economy, the dominant instinct of officials is often to try to shield the economy from volatility. But the crises of the 1990s helped demonstrate why this approach can be both futile and counterproductive. As economies become more open to capital flows, policies designed to insulate an economy from external shocks, whether they be fixed exchange rate regimes or selective capital controls and restrictions on international transactions, rarely offer durable stability, and they bring additional risks. These risks come in the form of additional distortions that might undermine future growth or magnify vulnerability to future financial volatility. The more promising approach is to invest in the complement of institutions and policies that enable an economy to live more comfortably with openness. Focusing on those measures that will enable an economy to be more flexible and to adapt more quickly to change ultimately will be a more effective policy strategy. It is politically more difficult, but economically more effective than those solutions that seem to offer protection from competition and volatility.”-Mr. Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, Trends in Asian Financial Sectors Conference, Federal Reserve Bank of San Francisco, San Francisco, 20 June 2007.

In this Issue:

Introspection on the US Markets and the Phisix
Deterioration in US Market Internals
Taxing Out the Bulls…
As the Yen hits Milestone Lows, We Monitor for Emergent Volatility
Our Phisix Outlook: From Bullish to Neutral

Introspection on the US Markets and the Phisix

THE performance of the Phisix remains remarkable so far, up .81% for the week and up 24.7% year to date. As we have always asserted, this has been so NOT MAINLY because of locally driven factors but because global conditions have prevailed which has been similarly manifested by a mostly buoyant activities in world equities. In our view, it has been the global central banks’ inflationary bias that has determined today’s financially driven asset based world economies.

Where today’s financial markets reflects heightened financial interlinkages and have grown increased correlations relative to its contemporaries compared to the previous years, it has become an imperative to examine the performances of the present stewards in today’s market actions.

Again, US markets has served as a sort of an “inspirational” pacesetter to global markets as much as to our own Phisix. While indeed the US markets have spearheaded a global rebound since February’s “Shanghai Surprise” as reflected by the advances of its key bellwethers such as the Dow Jones Industrials up 6.8%, S&P 500 5.9%, Nasdaq 7.2% based on Friday’s close, this confounding optimism comes curiously in the face of an economic “slowdown”.

What has been observed is that despite the unraveling bust in the real estate sector and continued concerns over the possible ramifications of the subprime mortgage woes, the continued levity in the financial sector has helped buttressed sentiment in the equity benchmarks, giving a picture of a largely unscathed economy, until today…

Figure 1 S & P: Sectoral Breakdown of the S & P 500

According to the sectoral breakdown of the industries of the major broad market barometer in the market value weighted S&P 500, the financials constitute a hefty 21.6% weighting in the index’s universe. What this means is that banks, investment houses, brokers-dealers, mortgage entities, insurances and other financial services represent the largest market cap weightings among US industries.

Figure 2: Yardeni.com: Profits from Financial versus Non-Financial

The significance of the financial sector has not been solely in terms of market value. Relative to corporate profits as shown in Figure 2 courtesy of Yardeni.com, the financial sector signifies about two-fifths of profits generated by Corporate America (All Corporations-Nonfinancial corporations).

Recently, the US financial markets was said to have been rattled by concerns of the recent spike in treasury yields, possibly signifying rising interest rates, as well as, persisting concerns of a possible diffusion by the deterioration in the finances of the housing related sectors. As of late, according to implode-a-meter.com 86 US lenders have now gone kaput.

To add to the lingering anxieties over the broadening of the housing epicenter based tremors, the current brouhaha over the failing hedge funds and Collateralized Debt Obligations or CDO’s appears to have signaled the proverbial “canary in the coal mine” as epitomized by the Bear Stern’s case where the investment house had been forced to bail out one of its two collapsing hedge fund due to substantial losses in the complex portfolio of structured finances (mostly from CDOs).

Lest we fall for the common man’s confirmation bias folly, or a cognitive bias which tends to show how we interpret events to confirm our preconceptions, we’d rather let the market to do the talking.

Deterioration in US Market Internals

Figure 3: Stockcharts.com: Financials Rolling Over?

Earlier we have shown the importance of the US financial sector to the US economy (relative to profits) and to the equity markets (relative to market value weightings). In Figure 3, the charts of the 4 financial benchmarks, S&P Bank Index ($BIX-lowest panel), Broker/Dealer Index-AMEX ($XBD-upper panel below the main window), Dow Jones US Mortgage Finance Index ($DJUSMF-upper window), and DJ US Financial Services Index ($DJUSFI-Center window) appears to be indicating an all important turning or inflection point.

The Bank and the main Financial Index has depicted lower highs and are at present working to test on critical supports, while the Mortgage Finance have broken critical support and appears to be rolling over, whereas the Broker/dealer index is drifting within the support areas.

Figure 4: stockcharts.com: More bad news?

Notwithstanding, we see other sectors of the S & P 500 (center window) likewise in rapidly deteriorating mode, particularly the S&P 500 Consumer Discretionary Sector Index which represents 10.5% of the index ($SPCC-upper pane below the center window), S&P Healthcare Index 11.9% of the index ($HCX-lowest window) and the Dow Jones Utilities 3.7% of the index ($UTIL- above pane).

Even the consumer staples 9.6% of the S&P benchmark (not shown in the chart display), which traditionally represents defensive plays (food/beverages, prescription drugs, tobacco and households products), have been shown on a downdraft much earlier than the recent actions in the major benchmarks, alongside with the Telecom services (3.7%).

Likewise, the Dow Jones Transports, a third component in the Dow theory, where the activities of the Utilities, Transport and the Industrial Averages have been used as indicators to either confirm each others actions in support of a trend or deviate to possibly indicate of an inflection point, has been shown in divergence with the Dow Industrial Averages and seen headed south. If such theory holds its utility then the declining Utilities and Transport are indicative of a declining Industrials.

On the other hand, the sectors keeping up the major bellwethers at their present elevated levels are the Energy (10.1% of the index), the Industrials (10.9%), the Info tech (14.9%), and the Materials (3.1%) sector.

In short, of the ten composite industries of the S&P 500, 6 industries representing a significant majority led by the financials, or 61% of total index weightings are presently showing signs of marked deceleration based on price actions.

So what we are so far witnessing are indicators of degenerating market internal actions which could lead to further selling pressures. As to whether the abovementioned fundamentals have prompted these remains to be seen.

Taxing Out the Bulls…

In addition, there could be other fundamental variables that could weigh in for the advantage of the bears. A much less talked about issue by the marketplace is that of taxation.

One of the structural boosters to the recent bout of buying has been due to the “shrinkage” of equity supplies brought about by the private equity boom, the supposed participation by sovereign wealth funds and massive buy backs from US corporations.

One taxation headwind entails a potential curb to the present pace of buyback based on the amended regulation that would close the circumvention of a tax law covering present repatriated earnings.

There have been some foreign subsidiaries of US companies like IBM that have taken advantage of certain legal loopholes to avoid on paying regular corporate taxes on repatriated earnings (IRS section 367 B) known as “Killer B” transactions which it had used to buyback shares.

Recently the US Internal Revenue Services (IRS) discovered the leakage and acted to plug on it, according to Gwen Robinson, whose article was posted at the FT Alphaville (highlight mine), ``On May 31, the IRS announced plans to issue regulations making companies pay US taxes when they buy back their stock, even if the shares are purchased by an international subsidiary. It said the planned ban on the practice would take effect that day, even though the regulations would not be finalised for some time. The new regulations would treat funds used for buybacks as repatriated earnings, making them subject to US corporate tax rates that are usually higher than international rates.”

Simply stated, by lifting the tax incentives to use repatriated earnings to buyback shares, the issue of equity supply shrinkage as a booster to the markets via buybacks from foreign subsidiaries of US companies could have been effectively reduced.

And as if by sheer coincidence we see MOST of the weaknesses from the US markets coming off after the IRS announcement. This is not to imply that the tax laws had CAUSED the decline, but instead to point out that such actions COULD have contributed to the apparent weakness seen lately.

Then there is another tax aspect. This one had been more visible than the “Killer B” transactions as it takes on the much ballyhooed private equity industry.

The US Congress recently proposed to tax the private equity industry that availed of special capital gains tax rates from “carried interest” provisions, as if direct its target to the recent Blackstone IPO.

According to the CNNMoney (highlight mine), ``Carried interest is a portion of the profits from an investment that's paid to the manager. In the private-equity business, it's often used to compensate managers for investing alongside their clients in a buyout.”

Mr. David Kotok of Cumberland Advisors says that such law/s will unduly undermine the incentives for private equity transactions, another pillar for today’s rising markets, quoting Mr. Kotok (highlight mine), ``Private equity deals are measured by the net present value of the exit strategy. Tax rates are a huge part of that calculation. Hence, this tax change is big and it reduces the present value of any future transaction.”

Adds Mr. Kotok (highlights mine), ``Markets are affected even if this never becomes law. The reason is that there is no way to know if it will pass and therefore any new private equity deal may be subject to the new tax structure. Our system exposes taxpayers to taxation once the law is introduced. If it is passed in the future, the date of introduction can govern the start of the tax impact and not the date of passage.”

With governments attempting to tax at everything that seems profitable, it wouldn’t be long where a series of unintended consequences could arise.

As the Yen hits Milestone Lows, We Monitor for Emergent Volatility

Finally there is the issue of the collapsing Yen.

Figure 5: Jack Crooks: Milestone Low Yen on Huge Open Interest Level

The Yen recently hit milestone lows relative to other major currencies. Against the Euro, the Yen fell into an all time record low level. Against the British Pound, the Yen fell to a fifteen year low, while vis-à-vis the US dollar the Yen fell into a four and a half year low.

This has been astounding in spite of the record trade surpluses and foreign exchange reserve buildup. It is remarkable how Japanese resident investors in search of higher returns have invested enormous amounts overseas compounded by the “carry trade” phenomenon which has led to such disproportionate decline to their currency.

While a declining yen could imply for further marketplace liquidity brought about by increased arbitrage to “riskier” assets, as Jack Crooks of the Black Swan Capital points out, the huge open interest in the bet against the Yen makes it appear as if there is no way for the Yen to go but DOWN!

Open Interest is the total number of futures or options on futures contracts that have not yet been offset or fulfilled for delivery (cme.com).

The significance of an open interest in the futures market is that it reveals the prevailing investor sentiment. According to George Kleinman, editor of Commodities Trends is that (highlight mine)``The size of the open interest reflects the intensity of the willingness of the participants to hold positions. Whenever prices move, someone wins and someone loses; the zero sum game. This is important to remember because when you think about the ramifications of changes in open interest you must think about it in the context of which way the market is moving at the time. An increase in open-interest shows a willingness on the part of the participants to enlarge their commitments.”

In Figure 5, courtesy of Jack Crooks, Yen’s record low decline against the US dollar has been accompanied by a huge spike in open interest.

In other words, investors have taken the decline of the Yen as a ONE WAY BET. And as a market saying goes, when everyone thinks the same then no one is thinking.

One way bets implies that an inflection point is imminent; this should also hold true with regards to the Yen. And a volatile yen could easily translate to equally volatile markets worldwide if one goes by the past behavior of a rising Yen. Recall the May 2006 and Feb “Shanghai Surprise” volatility? They were accompanied by a spiking Yen.

Our Phisix Outlook: From Bullish to Neutral

The coming week could be very interesting indeed. We could probably see a continued selloff in the US markets or a rebound off from the lows or a period of indecision or consolidation with a downside bias.

However, with the sentiment momentum going for the bears, aside from the deterioration in US market internals, and fundamental obstacles to the present bullish drivers, I am inclined to take the position that the US markets could try to ingest more profit taking sessions over the coming week or so.

Note, there is a difference here; I am predisposed to view of the any downdrafts as mere corrections or profit taking than a crisis at work, until of course proven otherwise.

As for the Philippine market context (as well as for most of its neighbors), there are two opposing forces at work.

On one hand, the bearish side is that as mentioned above, declining US markets could imply for a “short-term” spillover into the global markets. This would highly depend on the degree of volatility in the US markets.

However, the present market reactions have been distinct from the past. During the past encounters of volatility, we saw the US dollar firming, a broad “risky” asset class selloff (emerging markets, junk bonds and commodities) and a rally in US treasuries (declining yields).

On the other hand, the bullish premise for the Asian markets remains as formerly argued, the softening US dollar.

Today, we see a semblance of the “stagflationary” outcome similarly seen in the 70-80s, while one week does not a trend make, last week’s actions showed that infirmities in the US equity markets (Dow Jones Industrials and the S&P 500 down 2% over the week while Nasdaq down 1.44%), have been conjoined with a stubbornly high US treasury yields (drifting at the upper range; or at 5.138% from last week’s 5.17%), rising oil prices (WTIC over $69), relatively high commodity prices and most importantly a falling US dollar.

Another interesting aspect is the potential for a divergence to emerge, where Asian markets may continue to rise amidst a struggling US market, which actuality is long term expectation. Be reminded that the divergences could emerge only under the premise of orderly developments and not from excessive volatilities.

Where in the past the Phisix fell hard and steep as the US markets got clobbered, recently we have encountered sessions wherein steep declines in the US markets resulted to marginal declines in the Phisix.

With two contrasting forces, it would be difficult for us to make a short term call on the overall direction of the market.

From our end, we shift our outlook from bullish to neutral stance for the time being and would remain vigilant as to any incidences that may reflect an adverse “tailed event”.

Mind your stops.