Global Markets To A Rough Start, Phisix: Part of the Normal Corrective Phase

``It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.” --Gordon Gekko, fictional character from 1987 film Wall Street

2008 looks like a prelude to a very challenging year as global markets baptized the week with stinging losses as shown in figure 1.

In a single session for the week, Japan’s major benchmarks the Nikkei 225 and the TOPIX fell by a nasty 4% each. Meanwhile, the world’s inspirational leader, the major benchmarks of the US markets fumbled heftily for a worst 3 day start of any year since 1904 (Bloomberg). And this was likewise reflected in other key markets in Europe and in Emerging markets.

Figure 1: stockcharts.com: An ominous start for 2008?

Our own domestic bellwether the Phisix succumbed to its worst inaugural weekly decline since 1998. The 30-member composite yardstick fell 3.93% over the week and had been in a rolling decline marked by lower highs and lower lows seen in the main chart signified by the declining trend channel since October.

Moreover, the Phisix appears to be perched at its major support-200 day moving averages (red line) which is likely to be broken this week following the substantial losses in Wall Street last Friday. A meaningful breakdown underscores a transition towards a corrective phase.

The patent breakdown of the Japan’s Nikkei (upper pane below Phisix) could likewise be replicated in the S&P 500 (above pane). The US bellwether appears to have found some critical support at the 1,400 (in closing prices) area during the past few months. The recent lower highs should draw up a bearish declining triangle from which a breakdown could lead the S&P to the 1,300 zone. Otherwise, a bounce from this crucial support area could imply a bullish triple bottom but would need to be confirmed by a breach of the 1,525.

We see the same dynamics with Europe’s Stoxx 50, which appears to be testing its support.

All these tells us that global financial markets are presently adjusting to the unpleasant realities brought upon by the spillover of the US housing bubble meltdown, the global liquidity and credit crunch, the loss of trust on innovative financial products (securitization and derivatives), the return of risk aversion, the ramifications from a paradigm shift of monetarism (from banking to nonfinancial intermediaries or the “Shadow Banking System”-as labeled by PIMCO’s Paul McCulley) and the perceptible deceleration of economic growth previously stimulated by the “Ponzi” dynamics as seen through the massive speculative inflationary driven forces.

One important aspect overlooked by mainstream analysis is that today’s marketplace dislocation is a fundamental function of structural insolvency of the balance sheets by the US banking system (estimated at $12.7 trillion- Dr. John Hussman), rooted on borrowers who recklessly speculated on assets (in expectations of short-term gains and a perpetuation of jubilance) and who engaged in egregious consumption from whose debts have burgeoned to unwieldy magnitudes such that these have become unserviceable and have likewise been exacerbated by the collapse of assets from which such speculations were anchored to.

The continuing risks is that all these redounds to a monetary tightening as the banking system react defensively by hoarding capital via loss writeoffs and selling of assets or equities to boost reserves while simultaneously reducing money allocated for regular operations.

Needless to say, these implied tightening coupled with insolvent borrowers risks a potential contagion in consumer loans such as credit cards and auto loans (signs of rising delinquencies-Associated Press), or in other business aspects such as US commercial real estate or diminished capital expenditures.

Moreover, similar risk dynamics are seen affecting some major markets and economies in Europe which had similarly benefited from leveraged mortgage prompted property booms in UK, Spain, Ireland etc. (menafn.com), such that further afflictions of these markets may give rise to enhanced risks on state fiscal conditions (lower taxes on same level of expenditures leads to deficits) and heightens default risks on Credit Default Swaps, corporate High yield bonds and Derivatives Counterparties, aside from potential risks on residual losses from hedge funds and the nonfinancial banking system.

In effect, the financial sector which had served as a key backbone for the property boom in Anglo Saxon countries has now been suffering from the repercussions of its previous excesses.

In addition, recent economic data suggests that the US may already be in recession- “began a recession in December” as averred by PIMCO’s top honcho Bill Gross (nationalpost.com)-if not at the verge of recession, possibly evidenced by a sharp jump in unemployment to a 2 year high (Bloomberg) and a notable contraction in the manufacturing sector as measured in the ISM factory index-the most in 5 years (Bloomberg).

Now if past performance were to repeat itself, then the average losses as measured by the major equity benchmarks in the US from peak-to-trough during a recession is about 40%. This means that given today’s nearly 10% decline from the peak, major equity benchmarks could fall by another 30%. That is IF history will rhyme.

Yet, the present actions by central banks, such as the US Federal Reserve, mainly deal with the liquidity dimensions of the present problem. Some analysts opine that the recent actions of major central banks appear to be directed towards the “normalization” of LIBOR rates, aimed at stabilizing credit flows, which had earlier spiked relative to Fed rates, as discussed in December 10 to 14 edition, [see Market’s Response To The Fed’s 25 Basis Points: Sell The News] to evince of such tightened conditions. The LIBOR rate is a very significant reference rate used in the financial markets which are supposedly tied to some $150 TRILLION of derivative pricing (Jim Bianco as quoted by David Kotok of Cumberland Advisors).

While rate cuts cold help alleviate present circumstances it won’t sufficiently resolve the insolvency issues confronting both the borrower (general public) and the lender (balance sheets of the banking system) and the ensuing confidence crisis. With the current financial markets turmoil still persisting in spite of the recent activities by central banks to cushion its impact with the panoply of diversified measures, we can expect more intensified activities from monetary authorities going forward. So while financial compression in the private sector harries markets of western nations (deflation), global central banks are likely to concertedly exhaust their bandwith of arsenals to stave off a global recession (inflation). It is the appearance of “shocks” or black swans that risks destabilizing global markets.

Bottom line: What we expected to happen in 2007 appears more likely to occur in 2008. As seen in last week’s selling pressure, global financial markets are likely to face trying times as downside volatility seems to have reasserted itself. If the US is indeed undergoing a recession or falls into one over the short run, then the Phisix in tandem with other markets would initially feel its immediate impact. One must remember that the peak of US mortgage resets is still in process (from October 2007 through April 2008).

In short, while we believe the Phisix and Asia is in a secular bullmarket, countercycles are a normal and healthy component of any long term trend.