Voyaging The Unexplored World With Incomplete And Outdated Signposts

``I think there’s also a very real possibility that a lot of trouble could lie ahead. And at least my view, since we’re in uncharted waters, and I don’t think there’s a way to make a probabilistic judgment about where you are in that spectrum, I think we need to take these risks very seriously and I think that we should – from a policy perspective – take whatever measures we can find that we think are sensible to try to reduce that risk.”-former Treasury Secretary Robert Rubin quoted on WSJ blog

Next, we also find the recurring talks of the nominal measures of bear markets or of how the Philippine markets will react as the US enters into a recession. The idea is that US recessions or bear markets assume some quantifiable depth or duration dimensions that allows for the extent of the market stress to be identified. Such is premised on the assumption that historical performances are likely to repeat itself with near exactitude. The fallacy of this “appeal to the tradition” is where certain analyst projects the traditional-seen via lens of the “averages” or “median” of past activities-as the potential outcome for our market.

Figure 2: Bespokeinvest.typepad.com: Declining Duration of Recessions

As shown in Figure 2, courtesy of Bespokeinvest.typepad.com, over the past 100 years US recessions have been in a decline in terms of duration (days) or have become shorter. To quote Bespoke, ``For example, three of the first four recessions during the 20th Century lasted longer than 600 days. During the last four recessions, however, only one has been longer than 250 days (the longest was 487).” Some say that the average recession lasted by about 11 months while a severe recession extends up to 16 months (allbusiness.com).

While indeed the general trend has been down, you’d notice that there have been instances where the length of the economic contraction overshoots the declining trend (1929, 1973 and 1981). Thus, such trend does not signify today’s performance as a foolproof indicator that if the US will enter or is undergoing a recession today, the duration will be short, shallow or will be in within the “average” or “median” context.

Another, selecting reference points as indicator for the duration could be a point of contention. Biased analysts can or will use certain reference points to prove their case.

Figure 3: The Bear Market Cycle of the Phisix, Nikkei and the Nasdaq

Figure 3 shows of the different recession instigated bear market cycles.

For instance, the Phisix (top most chart) in the aftermath of the 1997 Asian crisis fell by about 66% from peak to trough in a span of 19 months. The blue arrows point to the interim or short term bottoms which biased analyst could utilize to prove their fallacious case of short bear cycles.

Since no trend goes in a straight line we saw the Phisix rebound sharply coincident with the assumption of a new President in 1998. Eventually the rebound tapered off and the Phisix resumed its long term bear market until 2002.

A similar case can be drawn from Nikkei’s first leg down (middle chart). After 62% loss in 31 months, Japan’s Nikkei appeared to have consolidated and bottomed out. However, the grizzlies shred up the bulls which eventually compounded the losses to about 80% (from the peak) in 13 years!

The dotcom bust is the same story (lowest chart). The full bear cycle of the Nasdaq saw its index fall by 75% in 30 months or over two years, where as shown above there had been four minor bear cycles juxtaposed with 3 countercyclical bullmarket within the secular bear market cycle.

Figure 4 Northern Trust: The Business Cycle and the S & P 500

Figure 4 shows of the interplay of the Business cycle with that of the S & P 500, courtesy of Northern Trust.

While one can compute for averages or medians, data shows that they hardly fall within the exact spots. To add, bear markets cannot simply be “boxed” or sterilized into “averages” or “median” simply because the driving factors from which the imbalances accrue and unravel were unique.

Further, the assumption of the averages or median does not even consider the underlying conditions that engendered the best and the worst case scenarios which eventually gets built into the equation of “averages” or “medians”.

Such is the reason why many investors including those armed with sophisticated math models get burned simply because they give weight to experience of the recent past (rear view mirror syndrome) or interpret data to fit their biases (confirmation bias).

Little have made use of the characteristics of a “Taleb distribution”, named after the Nicolas Taleb, author of the Fooled by Randomness and the Black Swan where as defined by Martin Wolf of the Financial Times, ``At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.” Giving undue emphasis to high probability events with modest gains, while ignoring risks of huge losses from a statistical deviation is a recipe for heavy portfolio losses.

Moreover, do any of today’s economic conditions or financial markets manifests of the so called averages or medians (see Figure 5)?

Figure 5: Economagic.com: Average? What Average? Where?

Not quite the average. Gleaned from the financial markets perspective, prices quoted or as reflected in its trends today do not reflect “typical” periods; the US dollar is on a milestone low (olive green line), 10 year US treasuries yields are knocking at a fresh multi-year lows, Energy prices (red line) are on the roof while precious metals (blue line) have just recently etched record highs even after the recent selloff.

So none of these appears to show significant correlation as with its contemporary past performance.

Figure 6: Danske Bank: BRIC versus OECD/yardeni.com: Exploding forex reserves

Even from the economic perspective, the outperformance of emerging markets relative to economic growth and reserves are other aspects of incomparable developments.

Figure 6 from Danske Bank shows the Leading Indicators of BRIC outperforming the OECD countries, and so with the exploding foreign exchange reserves of developing countries relative to industrial countries from yardeni.com.

Furthermore, consider the risks arising from Derivatives, notes Martin Weiss of moneyandmarkets.com (emphasis mine),

``At U.S. commercial banks alone, the total notional value of the derivatives is $172.2 trillion, according to the latest report by the U.S. Comptroller of the Currency (OCC). Plus, the OCC reports that:

``In over 90% of these derivatives, there is no established exchange that helps protect either party from default.

``Just FIVE major U.S. banks control 97% of all the bank-held derivatives in the United States, a concentration of power — and risk — unsurpassed in the history of finance.

``All five of these major players would likely be severely crippled, or even bankrupted, by the default of just a few major counterparties like Bear Stearns.

``Four have more credit exposure to counterparty defaults than they have capital.

``Two have over four times more credit exposure than capital.

Needless to say, derivative exposure by the US financial system to derivatives is unequaled in history. Yet, the loss estimates on the financial sector from the evolving mortgage-securities-derivatives crisis seems to be mounting: from $100 billion by Fed Chair Bernanke last July, $500 billion from Goldman Sachs now $1 to $2 trillion from Nouriel Roubini of New York University’s Stern School of Business!

Moreover, as the world’s biggest banks have absorbed $US195 billion in writedowns and losses on securities tied to subprime mortgages, Credit Suisse Group calculates that the 10 biggest US banks have the lowest capital levels in at least 17 years (theage.com.au)!

All of these go to show how today’s circumstances have simply been unprecedented. So how does the unparalleled or extraordinary circumstances equate to “averages” or “median” as sold by analysts is beyond me.

As a caveat, this doesn’t imply that we are bearish but instead recognize the risks involved under the current circumstances are totally different from any period of time to make valid comparisons.

Dr. Marc Faber discusses the discerning insights of market sage Peter L. Bernstein, author of the magnificent book Against the Gods, the Remarkable Story of Risk (a must read for market practitioners).…

This lengthy but fitting quote from Dr. Faber…

``Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled “Uncharted Territories” that “the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health... There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969.”

``Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of “strains in the resources of the system, such as high levels of capacity utilization and low unemployment”. (Peter Bernstein has developed a “Strain Indicator”, which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator “has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs”.)

``But Peter Bernstein isn’t optimistic about the economy. In asking himself the questions “what is going to happen next?” and “what is the outlook?”, he explains: “[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us.”

``In referring to some of the unique features in the current scene – mentioned briefly above – Peter opines:

`` [W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer’s piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture – drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up.”

``The author Dave Wilbur has said: “One of the world’s greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it.”

``Similarly, Peter Bernstein concludes his report with the observation that “there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster.” During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: “There are old pilots and there are bold pilots, but there are no old, bold pilots.” Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.”

Figure 7: Northern Trust: Largest Fed Cuts (in percent) since 1982!

Even monetary policies applied to the present circumstances by the US Federal Reserve has been relatively unorthodox, unconventional or most aggressive by historical measures (the use of depression era laws to rescue Bear Sterns, aside from the emergency lending policy bypass used by the Fed to accommodate lending for securities firms at a similar rate to commercial banks underscores the severity of present conditions).

This form Asha Bangalore of Northern Trust (highlight mine)…

``The Fed’s record in the August 2007 – March 2008 period will probably go down in history as the most aggressive and creative. The TAF, TSLF, and PDCF programs are its creative endeavors aimed at reducing the credit crunch and liquidity problems, while the sharp reduction in the federal funds rate is the aggressive feature of monetary policy changes in recent months. The FOMC has reduced the funds rate 300 bps between September 18, 2007 and March 2008. In nearly 26 years, such an eye popping drop in the federal funds rate in a seven-month period occurred only between August 1984 and March 1985 during Chairman Paul Volcker’s term.

``In terms of a percent change, the latest 300 bps cut in the federal funds rate is the largest (57.1% drop) since September 1982. The only period when it was close to the recent drop was a 55.5% decline in the seven months ended November 2001.”

In sum, all of these should extrapolate to a cautious, conservative and defensive stance as well as its accompanying actions aside from adopting open mindedness and flexibility than get suckered by our biases.

Remember, voyaging in unexplored territories means that we have little clue of what to expect and of the risks we are faced with. But learning from Warren Buffett simply means we cannot afford to freeze and should face up with the circumstances, ``On fears of a crash or meltdown or bad things happening in the market…Something bad will happen, but you could go back at anytime in the last 100 years and say the same thing...you can freeze yourself out indefinitely.’ Every investor must play the hand he is dealt.”

The debt crisis abroad is actually a process where non productive or speculative debt or Ponzi debt structure (Minsky model) is being destroyed. Eventually this “destructive process” will reach a culmination point where economic activity may be able sustain the level of debt in the economy, thus the storm will pass, as the contagion “forced selling” effect would have peaked-as with any normal cyclical transitions. It is not the end of the world as we know it, but part of a necessary market cleansing process. It does take time though.

We are not a stranger to this (go back to figure 3); the Phisix confronted the same phenomenon during the Asian Crisis of 1997 and agonized for 6 years. Japan’s Nikkei had a horrid 13 year of painful adjustments from such unsustainable debt levels. The Nasdaq crash took over 2 years to recover and was also a consequence of outsized leverage but restricted to the corporate sector.

All we can say with a little more definitiveness is that the continuing financial crisis will demand more actions from the authorities to the point of undertaking massive subsidies from which the latter would comply. The Financial Times says that major Central Banks are now discussing ways to absorb mortgage losses using taxpayers money to fund the losses!

The problem with this route is one of the unintended or unforeseen effects of more interventions (moral hazard, probable path to hyperinflation or global depression, extreme currency debasement, bubbles in new assets and others) from which may extend or defer the day of reckoning of the present imbalances from taking its natural path of adjustments or which may exacerbate the systemic risks to even more vastly unsustainable levels.

Yes, while cyclical divergences allow us to be more confident of the future relative to the fundamental standpoint of domestic or regional economy or markets, it would be best to heed the prudent advice of Mr. Peter Bernstein and Dr. Marc Faber who posits that we should avoid the road to disaster by eluding the presumption of knowing with absolute certainty what the future holds, based on incomplete and outdated sign post that go by.

To our understanding the domestic market is undergoing a normal countercyclical interim bear market phase as it is digesting both the pressures from the credit instigated losses abroad and the necessary adjustments from the valuations standpoint predicated from an economic downshift. But considering the cyclical aspects of the domestic economy and the local financial markets we are likely to be operating from a secular bullmarket until proven otherwise, although risks from the unexplored global conditions should dictate for more prudent actions.

Last, we should be aware of the incentives of the proponents of the both extreme scenarios, since many of them thrive on business models which require the fulfillment of their wishes or advocacies rather than the representation of objective analysis.