In A Crisis, Be Aware Of The Danger But Recognize The Opportunity

``Hope and denial do not constitute a successful investing strategy. More money is lost by people listening to their emotions and ignoring facts than is lost because of just about any other influence.”-Bill Fleckentstein, MSN Money Contributor

ON the road to vacation, I chanced upon a rather queer article from a veteran stock market analyst on a business broadsheet. The narrative incited for local market participants or the purported “weak” hands to “panic” so as to “end” this dreadful bear market. Obviously, the bizarre straw man argument undeservingly nitpicked on the domestic players when it is the foreign participants mainly responsible for the recent carnage.

While the essay appeared to be a “reverse psychology”, which was meant to do otherwise, it signifies pretty much of a deeply entrenched state of denial-the inability to accept the persistence of the present conditions. This seems to reflect signs of impatience and deepening frustration from a supposed market expert. As German-Swiss author poet Hermann Hesse in his novel Steppenwolf wrote, ``All interpretation, all psychology, all attempts to make things comprehensible, require the medium of theories, mythologies and lies."

As discussed in last week’s Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist”, since the Philippine financial markets has not evinced signs of a reversal from its internal or “local” cycle but rather has been reacting to the impact of bubble implosions (real estate and securitization) abroad, we are likely to be undergoing a typical “corrective” countercyclical phase than of a secular turnaround.

The point is to understand the underlying cycles driving our markets than speciously look for momentum and sentiment driven reactions and rationalization. To wit, the spate of foreign driven selling has been prominently impelled by “forced liquidations” of institutions in a frenetic effort to raise or shore up capital or meet margin requirements as lenders tighten up or fulfill investor redemptions, which translates to selling of the most liquid and even safest papers.

To quote the Economist (highlight mine), ``The fear is that the financial markets have entered a negative spiral with being forced to sell bonds and loans, whether or not they believe the borrowers will eventually repay. The problems are exacerbated by the demise of the securitisation market, and fears about counterparty risk. Both those factors are making banks less willing to lend—even to worthy borrowers. They will become even more cautious the deeper America’s economy tips into recession.” For example, Louis-Vincent Gave of Gavekal Research notes, ``tax-free AAA municipal bonds started to yield more than the equivalent US government bonds. Given the tax differentials, this makes no sense at all.” (emphasis mine)

As you can see the consequent fear and the forced offloading, which signifies a hoarding effect is a natural consequence of the breakdown in the securities market, has distorted the pricing of securities in the world financial markets. And under a globalized environment, we are feeling the heat of such contagion, so as in most parts of the world.

Secondarily, “adjustments on effective valuations” emanating from the perceived economic slowdown in the wake of the evolving debt crisis is another variable from which global markets appear to be exhibiting.

This cyclicality is best illustrated by the description of Citibank’s Credit strategist Mark King of the four phases of a credit cycle (hat tip: David Fuller). Quoting Mark King (underscore mine)…

`` Phase 1: Long credit, Short equity

``This phase immediately follows the bottom of the credit bear market. Spreads fall sharply as companies complete the process of repairing balance sheets, often through deeply discounted share issues (as we saw for Insurance and Telecom companies back in 2002-03). This, along with continued pressure on profits, keeps equities weak.

``Phase 2: Long credit, Long equity

``The next phase begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflow rises strongly. We call this an immature equity bull market. For the present cycle, this phase began in March 2003 and finished in the middle of the 2007.

``Phase 3: Short credit, Long equity

``The credit bull market is over, balance sheet leverage increases, spreads rise, and investor appetite for credit wanes. Financial market volatility rises. As we progress through Phase 3, the equity market eventually decouples from credit and continues to rise. This is the mature equity bull market.

``Phase 4: Short credit, Short equity

``This is the classic bear market, when equity and credit prices re-couple and fall together. It is usually associated with falling profits and worsening balance sheets. Concerns about insolvency plague the credit market, while broad profit concerns plague the equity market. A defensive strategy is most appropriate - cash and government bonds are the best performing asset classes.

The credit cycle as defined by Citibank’s Mark King suggest to us that the US is most likely in Phase 4, as shown in Figure 1.

Figure 1: St. Louis Fed: Panic in Wall Street-Fed Pushing On a String?

3-month Treasury rates have plummeted close to zero or to three fifths of one percent (blue line), even as Fed funds is now at 2.25%. If Fed rates (red line) historically track the performance of 3 month treasuries (as far back to 1982) then they appear to be signaling Fed rates at one percent or below. Wow, such panic seems written all over Wall Street! But the stock market hasn’t demonstrated the same degree of fear. So our guess is that one of them (stock market or bond market) could be wrong.

But the question is how much more room can FED policies adjust before the market responds favorably? In other words, conventional policies appear to be losing traction even as FED rates are approaching zero. Hence, the risk of “Pushing on a String” or Fed’s policies pushing on one end does not appear to produce the desired movement at the other end. For Keynesians it is known as the “Liquidity trap”, where the next step would probably be our version of TSLF or Total Socialization of Losses of the Financials or Bernanke’s Helicopter Money.

Likewise the 5 year Treasury Indexed Note (green line) or TIPS is now at negative yield territories, where to quote Bill Bonner of the Daily Reckoning, ``These TIPS provide protection from both enemies – inflation and deflation. The feds won’t default. And the TIPS adjust to losses in consumer purchasing power – as calculated by, well, the feds themselves. But so great is the demand for this kind of protection that investors are willing to give up all hope of a current yield in order to own them.” (emphasis mine)

All this goes to show how global investors have indiscriminately dumped most assets and gravitated or shifted towards safehaven issues in search of a protective shelter from the prospects of both defaults or deflation and inflation.

Nevertheless, based on the Mark King’s Credit cycle, the US and other heavily levered developed economies appears to be in phase 4 as the credit losses deepens, while the Philippines does not share the same fundamentals.

On the contrary we seem to be situated in between the Phase 1: Long credit, Short equity and the Phase 2: Long credit, Long equity of the King credit cycle as evidenced by repairing of balance sheets, greatly reduced leverages, exploding foreign exchange reserves, declining fiscal deficits, falling yield spreads, rising cash flows…all of which seem to suggest that fundamentally we do not share the same flaws as the external influences affecting us. Thus, instead of fear and denial, today’s credit crisis ought to be seen in the light of opportunities which may be lurching at the corner. After all, it is all a matter of perception.

In a speech in Indianapolis, April 12, 1959, former President John F. Kennedy (1917 - 1963) conveys of the best lesson one can learn from a crisis, ``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity.”