Portfolio Management Under Today’s Stressful Market Environment

A Premature Call or One Week Does Not a Trend Make?

``The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”-Joan Robinson, Cambridge University (1903-1983)

Hardly has the ink dried from our last outlook, when financial markets across the globe started falling apart. Could we have spoken way too soon?

Worst of all, what we asserted as possible seminal evidence of financial market “decoupling” got slammed, as shown in Figure 1.

Figure 1:stockcharts.com: Global Markets Cracking UP?

The Philippine benchmark, the Phisix (center window) suffered its worst single week loss steeply down 9.57%, since the week that ended August 16 in 2007. Year to date the Phisix, prompted by a streak of intense foreign selling, has lost 12.52%, with barely a month into 2008!

Worldwide, most of the reactions have been the same, the Dow Jones World Index (above pane), the Fidelity Southeast Asian Fund (pane below center window) and the Templeton BRIC Fund (lowest pane) all showing a technical breakdown from critical support levels.

Again, with the exception of benchmarks Gulf Countries which continues to appear immune from the recent global pressures and some select bourses, such as Jamaica, Ukraine Taiwan (possibly for insulated reasons this week), and some others, it is broadly a sea of blood out there for last week.

Warren Buffett on Bond Insurers: Watching fires Burn Across The River

``The battlefield is a scene of constant chaos. The winner will be the one who controls that chaos, both his own and the enemies.” -- Napoleon Bonaparte

While in the past a misread on the reaction of local investors evoked a sense of panic on my part early August (discussed last week), most of what I have written then is coming into pass this time around.

In other words, this is sheer evidence of how attempting to “time markets” over the short term is almost an impossible task. Investing in the financial markets using ticker based assessments usually results to disastrous outcomes especially at critical turns and mostly when trading and or investing disciplines and money management are sacrificed at the altar of momentum or emotionally driven impulses. The previous pressure of “missing rallies” has now morphed into fear today for many market participants.

Again the formula of perceptive observation applied to judicious risk analysis combined with enduring patience and strict adherence to one’s investing discipline equals outsized returns through minimized risks. This can be epitomized by the latest activities of the world’s best stockmarket investor, the sage of Omaha, Mr. Warren Buffett.

In 2003, Warren Buffett vehemently argued against the use of derivatives, labeling it as a “Financial Weapon of Mass Destruction” (bbc.co.uk). This was publicly debated by with former Fed Chief Alan Greenspan (Forbes: The Great Derivatives Smackdown) and other financial experts and market participants who dismissed Mr. Buffett’s admonitions.

Four and a half years later, derivatives have been a key contributor in today’s financial turmoil and could likely be the epicenter of the next wave of leverage implosion via credit derivatives known as Credit Default Swaps or among counterparties in many suspect derivatives contract-known as Counterparty risks.

The Notional amount or Over-The-Counter Derivative contracts have grown to an astounding $516 trillion as of June 2007 (bis.org), with Credit derivatives expected to grow to some $33 trillion (bba.org.uk) or according to some estimates at $45 trillion (Forbes).

And for Mr. Buffett, a field littered with casualties from failed derivative gambits as seen in the Bond Insurance industry covering mainstays as ACA Financial Guarantee, AMBAC Financial Group Inc, MBIA Inc., Radian Group and others (money.cnn.com), becomes a timely opportunity for his entry, through his flagship Berkshire Hathaway, into the severely battered industry (ft.com).

Mr. Buffett appears to practice an age old Chinese proverb which deals with the warfare stratagem of “Watch the fire burning across the river”. The enemy dealing maneuver is part of the 36 collection of stratagems which advocates ``delay [in] entering the field of battle until all the other players have become exhausted fighting amongst themselves. Then go in full strength and pick up the pieces (wikipedia.org).”

With the industry mainstays running themselves aground through imprudent speculations, and neglectful evaluations of risks, Berkshire Hathaway is in the process of cornering the industry business from the fallen warriors.

So who among us can painstakingly wait for four-and-a-half years to seize an opportunity? Such is the redoubtable virtues Mr. Buffett seem to be preaching to us.

Selling Reaches Extreme Levels, Potential Bounce Soon?

That said, today’s selling pressures could likely be distinct from that in July-August of last year.

Our feedback is that some of the expectations seem geared towards the impression that the markets could deliver a similar reaction relative to last year. Hence, the assumption that today’s market ruckus is merely a short-term blip. Hopefully they are right. But for us, last year’s initial tremors seem to be more like a practice drill for today’s more earthshaking market action over the next months.

In July 2007, the violent gyrations in the global equity markets had been principally in response to the sudden seizure of credit access in US-Europe financial system. Following a rapid gamut of actions from global central banks, such tightness appears to have eased considerably since (Reuters).

Nonetheless, the distinguishing aspect from then is that markets appear to be pricing in an intense global slowdown possibly via the snowballing expectations of a US Recession…TODAY! Yes, that is according to Merrill Lynch, Goldman Sachs (telegraph) and others.

The sharp decline in commodities, equity markets and 40% collapse of the Baltic Dry Index, against a backdrop of a fierce rally US Treasuries (sharply falling yields), surging Japanese Yen (unwinding carry trades) and bottoming out of the US dollar Index have chimed in to emit a unified message.

True enough, brutal selloffs similar to last week may result to a sharp rebound as technical and sentiment indicators seem to have touched extreme levels, see Figure 2.

Figure 2: US Global Investors: Negative Two Standard Deviations

Mr. Frank Holmes of US Global Investors suggests that these areas of extremes are measured by a statistical tool called Standard deviations (SD) or a measure of statistical dispersion, which assess the spread of values in a data set. If many points in the data set are close to the mean then the SD is small, while if many points are far from the mean then the SD is large, whereas if all the data are equal then SD is zero (wikipedia.org).

According to Frank Holmes of US Global Investors (highlight ours): ``Over the past 60 trading days, the S&P 500 has dropped 14 percent. A decline of this magnitude last occurred about five years ago. As can be seen on the chart above [left pane-BT], this correction is approaching the same magnitude of other gut-wrenching events such as the collapse of Long Term Capital Management in 1998; Sept. 11, 2001; and the collapse of the technology bubble and the bear market that ensued in 2002.

Such high rarely occurring SDs, can also be seen in the histogram graph at the right pane, notes Mr. Holmes, ``The 60-day change on the S&P 500 has now fallen 2.18 standard deviations from the mean. There are very few periods with worse 60-day returns. In other words, odds favor a rebound from these levels.”

Why? Mr. Holmes adds, ``When markets fall for an extended period, or just have very sharp short-term corrections, fear begins to creep into investors’ psyches, and they begin to make irrational decisions. This becomes an opportunity for the investor who understands history and the math behind the market. These charts help us quantify the magnitude of the markets’ ups and downs and help us make better risk-adjusted decisions (emphasis mine).”

Given the technical oversold levels and the accelerating “fear” factor in the investing community, such extremes levels could trigger a ferocious short covering aside from potential short-term insurrection from the bulls.

But underlying question is will any forthcoming rally last?

Secular or Cyclical Trends, US Markets as Drivers and Opportunity Windows

The important thing to understand today is that since the market actions in the Phisix is STILL TIED to, or remains “COUPLED” to the activities in the US, the fate of the US markets remains of considerable influence to our forward direction over the interim. Hence the analysis of US markets, economy and forward policies are paramount.

Second is to identify and understand whether today’s declining phase comes out of a REVERSAL of the long term trend or simply a COUNTERCYCLICAL action, as we discussed in our October 23 to 27, 2006 edition, [see Should You Invest in the Phisix Today?].

If markets reveal that the secular trend has changed then necessary MAJOR actions need to be taken in one’s portfolio to adjust to the new conditions.

However, if markets merely suggests of transitional cyclical phases of mean reversion, or in the observation of legendary trader Jesse Livermore’s axiom, NO TREND goes in a STRAIGHT LINE, then it is normal to expect interim trends, such as a cyclical bear market phase amidst a secular bull market and vice versa, where slight portfolio adjustments could be made relative to one’s risk profile.

To consider, if sentiment reasons has purely weighed on the Philippine markets relative to a fundamental impacted credit-impaired US markets, essentially given Warren Buffett’s dictum where we have to be “greedy when everybody is fearful and fearful when everybody is greedy” then present opportunities poses as selective buying windows especially as prices are marked even lower out of plain investor psyche-fear. Yes, be reminded that ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised,” which is again another quote from Warren Buffett.

If it took the prescient Mr. Buffett more than 4 years to be proven right (again and again) with respect to derivatives (previously to the tech boom), then isn’t he now taking advantage of someone else’s or a majority’s folly or the present crisis as an opportunity to profit from? Why then fall for momentum or the bandwagon effect-which is after all another important psychological factor for underpinning today’s crash?

Again all these depends on one’s time frame and risks expectations; where participants has to reckon whether they are in the market for the punt or for momentum trades or for long term investing.

Measuring the Bad News

And since the US markets continue to serve as the world’s inspirational leader, persisting pressures emanating from the knock on effects of the imploding leverages within its financial system are taking its toll on global equity markets.

The contagion effect has been far reaching, from mortgages backed securities to Asset backed securities to Credit Debt Obligations and now to Bond Insurers, Credit default swaps on commercial property sector…as shown in Figure 3.

Figure 3: Danske Bank: More Bad News

The business of bond insurers is to underwrite insurance policies of bond issuers relative to missed payments or defaults. In the past, monolines (sole business is bond insurance) covered mostly municipal bonds. But the monumental bubble in the real estate sector induced a bandwagon effect of luring these insurers to expand its earnings by adopting complex risks models as mortgage backed securities and Credit Default Swaps in their portfolio.

The recent fallout from the collapsing mortgage backed securities have prompted a downgrade on several monoline insurers as MBIA, the largest bond insurer (wikipedia.org), which has lost about 85% of its share price (see topmost chart), as bond insurers are faced with huge payments on rising loan defaults. These companies have insufficient funding and/or capital to pay out on the insurance.

Further Chief Economist Steen Bocian of Danske Bank lists of the ramifications and other risks facing the US financial markets (emphasis ours), ``Bond insurers represent one of the systemic risks that have been a “ticking bomb” under the financial system. If the bond insurers get downgraded, their insurance will obviously lose value and the bonds they have insured will also likely be downgraded. This can trigger forced selling from investors that are holding the insured bonds if they are only allowed to invest in bonds with a high rating.

``Another risk at the moment comes from the commercial property sector. The activity in this sector has held up well but may start to be hit by the credit crisis and thus add to the woes in the construction sector. The Fed’s Beige Book reported that “reports on commercial real estate activity varied, with some reports noting signs of softening demand”.

Such far reaching contagion, which in essence signifies the question of the solvency of the US banking system, brings us to our earlier premise that global markets appear to be pricing in a recession scenario for the US economy.

Figure 3 from Northern Trust shows as how the S & P 500 performed from PEAK to TROUGH prior to and during a recession.

Figure 3 Northern Trust: The S&P 500 and Economic Recessions

Ms. Asha Bangalore of Northern Trust underscores two conclusions from the above, (highlight mine),

``(1). The S&P 500 is a leading indicator par excellence. Since the 1950s, the S&P 500 has always peaked before the peak of a business cycle, with one exception (1980 business cycle). The S&P 500 establishes a trough prior to the end of a recession without exception.

`` (2). The median percent decline of the S&P 500 from its peak to trough is 16.9%. In the first three business days of 2008, the S&P 500 is down nearly 7.0% from its peak in October 2007. If history is a guide, brace yourselves for a rough ride in the months ahead.”

From its peak in October 9 of 2007, the S & P 500 is about 15% down (Friday close) which is nearly within the median loss and 4% short of the average loss during the past cycles.

This isn’t to imply that we have reached the bottom; such would assume the average or median as the base. What we can say is that the path of least resistance is DOWN for the time being.

And that if a recession is truly underway or we are close to it, depending on the extent of impact on the economy- the degree or depth-and the response to the attendant policies aside from the duration-losses can go as high as 40% (1973-74) or 30% (2000-2001).

One must remember the meat of the losses occur during the transition towards a recession, as John Hussman wrote (emphasis ours), ``A large portion of bear market losses occur while investors are still denying the probability of a recession. By the time that a recession is well-recognized, significant damage has already been inflicted.

From which Mr. Hussman delivers a difficult poignant and pragmatic advice for the average market participant (highlight ours), `` For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy. It's likely that most investors who “caught” the rally in the stock market earlier this year never got out, because the features that would have prompted them to reduce risk (overvaluation, overbought conditions, overbullish sentiment) were the same conditions that would have prevented them from taking risk in the first place.”

Accepting Risk That We Can Retain

So what to do?

Again under the present circumstances, the degree of decline in the US markets aside from the behavior of other asset classes appear to indicate that the US could be in a recession, where using historical performance could lead to more losses if not a prolonged period of rough sailing ahead.

The impact of the present adjustments will depend on the how the US economy and markets responds to the policies adopted by the US government in reaction to the present deteriorating circumstances.

President Bush recently pushed for a $145 billion plan as safety net, alongside Bernanke’s recent avowed support for fiscal stimulus, which could complement central bank actions. So far the markets seem to have discounted these and continue to stagger. According to Calculated Risk, market expectations are priced in for a 75 basis points cut with the odds of 100 basis points of implied probability rising further. This implies that the financial markets expect more aggressiveness in policy actions. Question is: will authorities oblige?

The path towards expansionary policies in the US and elsewhere will have different impacts to different asset classes and should be evident soon (maybe as new measures are implemented), but for the moment markets will remain synchronized as the focus remains on the potential bandwith of the credit-securitization-derivatives induced losses and its repercussions to the broader financial system and the economy.

If global markets have been driven by sentiments than of fundamentals, the likelihood is that “decoupling” will probably reappear in the form of earlier recovery than outright dissociation.

Because extreme situations suggest of a near occurrence of a countertrend (meaning a bounce soon), it would be reasonable to adjust portfolios according to one’s risk profile under a defensive stance. To paraphrase Mr. Hussman, to accept risk…that we can be reasonably expect to retain.