Phisix: No Bubble! Time for Greed Amidst Fear

``So much of what we hear and what we're taught turns out to be false on closer scrutiny. Whether it is expert advice, what you read in the paper, or what your mother told you, if it is important, take the time to figure out for yourself whether it is really true.”-Steven D. Levitt, Co-Author of Freakonomics, on Figuring Things Out for Yourself

True to the functional transitions of the psychological cycle underpinning the general market’s direction, emotions have been sweeping away rationality like clockwork.

Some Signs of Psychological Capitulation!

Where in a downside cycle, mid stage characteristics as “desperation” and “panic” segues into the finale phase of “capitulation” and “despondency”, some market participants seem to have evinced symptoms of outright dejection by undertaking redemptions, or have utterly avoided or have completely lost interest, while others have even resorted to faultfinding.

These in conjunction with inordinately depressed market sentiment indicators and fundamental developments seem to reinforce our view that Phisix is likely to be nearing a bottom or could be in the inchoate juncture of a bottom formation in contrast to the mainstream thinking.

The basic problem for any investor is forecasting the future accurately. In determining the potential outcome of the markets, if the experts are vulnerable enough to fall for cognitive biases (heuristics or mental shortcuts), thus, it is natural to expect the public (who do not apply rigorous analysis) to give weight to the present direction of the ticker tape activities as the future outcome (recency bias). Yet unknowingly to latter, such biases could be detrimental to the performance of one’s portfolio, if not one’s health (physical or mental) or to relationships.

For instance, when the trend is up, the proclivity is to plough into the market using ANY justifications (available bias) while ignoring risk factors. Peer pressures lend to “missing or chasing the rally” attitude and the need to be “IN” popular trades, all of which expands risk taking activities while reducing returns.

“Experts” are expected to possess the magical powers of the Talisman to predict the next market darling. With the use technical instruments, the public is lured to catch short term “tops and bottoms” from which the legendary Jesse Livermore cautioned everybody wants “to get something for nothing”.

And when the trend is down, the hope of recovery dims, risk aversion grows while the appetite for financial voodoo vanishes, condemnation and depression eventually governs. This is the unfortunate, unpalatable and revolting realism of the marketplace; people simply get what they deserve.

This is where we would like to differ. As we have repeatedly argued, our observation is that long term trends in every asset cycle are basically determined by the Inflating or Deflating of Bubble cycles, operating under today’s monetary “paper money” framework.

Yes, despite the realization of an unfolding bear market today, our belief is that the long term cycle remains grounded in the ADVANCE phase and today’s decline accounts for a cyclical speed bump on the following premises:

1. There are NO signs of a local bubble yet.

2. Every asset boom bust cycles are determined by expansive growth or reversals of frenetic speculation powered by an overdose of leverage from massive credit and or money expansion. We don’t see them yet in the Phisix or the Philippine Economy.

3. The long term risk reward tradeoffs in the markets greatly depends on understanding the dynamics of how the bubble cycle impacts our investments and correspondingly applying such knowledge to balancing our portfolio, profitably.

Parabolic Prices In My Dreams

Today’s bear market is likely to be a temporary phenomenon. Why? Because the Phisix has climbed only by 2.8x from trough to peak in FOUR years (June 2003-July 2007) as compared to the recent experiences of Saudi’s Tadawul and China’s Shanghai Composite (see linked charts) which has exploded by 5.7x and 5x in just TWO-THREE years.

Why the indices of China and Saudi you ask? Because these bourses have exhibited exemplary volatility, in terms of speed and velocity and the duration and scale of movements, which has almost replicated a bubble’s behavior.

Yes, while China’s bourses have suffered from a steep decline (have lost nearly 50%), it has made an astounding rebound over the past two weeks. Meanwhile, despite the abrupt drop of about 65% from its zenith in February 2006, Saudi’s Tadawul seems visibly bottoming out after more than a year of consolidation and looks forward to the next wave up.

What seems to be noteworthy in the activities of both bourses is Newton’s third law of Motion at work, ``Every action has an equal and opposite reaction”.

The lesson is pretty clear: the magnitude of volatility reflects the scale of momentum swings-SHARP SPIKES EQUAL DRAMATIC DECLINES!

However, if we are to examine the phenomenon of how a bubble evolves, we can discern that the action of these bourses as possibly still in a bullish phase over a long period.

Figure 1: Moneyweek.com: Stages In A Bubble

Figure 1 courtesy of Dominic Frisby of moneyweek.com depicts of how bubbles in asset classes develop and unravel.

As you can see from the above diagram, ALL bubbles undergo transitions from the STEALTH phase to the AWARENESS phase to the MANIA phase to the BLOWOFF phase.

This means that incipient trends are generally unrecognized or incubated in a “stealth” phase and are seen or engaged only by a few contrarians “smart money”. As the trend gets accepted or reinforced, this draws in more institutional participants or the awareness phase.

The trend eventually gets a wider audience, but gets tested (First sell off or the bear trap).

Following a successful test, the “tipping point” has now been attained as evidenced by deepening convictions which eventually leads to a broadening of the participation from the general public, bolstered by media as the market transits to the mania phase.

Enthusiasm or cautious optimism then morphs into greed, excessive risk taking, feelings of infallibility or overconfidence and the delusions of permanent grandness or the proliferation of infamous equivalent phrases of “this time its different” or “new paradigm”, where deep-seated convictions clashes with realities. This represents as the Blow-off phase.

Eventually a climax is reached, reality pervades, the house of cards fall under its own weight (or prompted by policy shifts) and the bubble pops. The whole cycle goes into a full reverse.

So where is the Phisix today, according to the bubble cycle?

Figure 2: Phisix’s Monthly: First Major Test?

First, let us use the past cycle of the Phisix as an example as shown in Figure 2.

In the 1986 to 2003 cycle (blue frame), the Phisix entered into the awareness phase in 1986 and encountered its first major test which was apparently triggered by an aborted coup d'état attempt at Camp Aguinaldo in 1987. The next “test” came with another botched coup attempt in December 1989 at Makati. Both “tests” incurred losses of nearly 50% spread over 1-1/2 years before recovering.

What happened after the “tests”? The Phisix skyrocketed by 458% in three years (1991-1994)!

When the Asian Financial Crisis scourge hit the Phisix, we saw the same dynamics as seen in the Saudi-China’s model, Newton’s “Every action has an equal and opposite reaction” in motion. The Phisix lost more than two thirds of its gains, bounced back ex-post the Presidential elections and excruciatingly returned every gains it accrued during the bounce, over the next three years or until late 2002 to early 2003.

Today, following the completion of the full cycle, the Phisix appears to be in an awareness phase which seems to have met its first acid test or its baptismal resistance or its bear market trap after FOUR years, see again figure 2.

This means that if I am correct about the interpretation of the next phase of the Phisix, it is likely that once the recovery gets a firm footing, the next velocity of gains will eclipse the performance of 2003-2007. Think about it, if the Phisix should repeat its past 400% gains from present levels, this means that the Phisix should reach more than 13,000, way above my 10,000 forecast!

No Signs of Public Exuberance or Euphoria

Next, another prominent feature of a bubble is pubic exuberance.

As shown in our bubble diagram, each of the phases exhibits different types of investor involvement.

The stealth phase attracts SMART Money or the Contrarian players (remember our Phisix 2002, mining in 2003, Peso in 2004), the awareness part draws in INSTITUTIONAL money and lastly, RETAIL investors jump on the bandwagon in a MANIA which then leads to the final BLOW OFF phase.

We have seen this happen in China just recently before the “bubble popped”, where 250,000 new accounts were opened daily by retail investors including maids (estimated 99 million new accounts in 2007-sovereign society)!

Have we seen a profusion of public participation as manifested by a massive influx of retail players? I doubt so.

I have previously shown this chart in my outlook.

Figure 3: PSE Daily Trades: Best measure of Local Speculative Activity

We don’t have data on the opening of number of NEW accounts, but we can have a rough approximation of retail activities as signified by the number of trades.

Since retail investors tend to be short term players, my impression is that the rising trend of the daily trades reflects on the speculative activities of retail investors.

As shown in Figure 3, although yes, there had been some signs of a build up of speculative activities from mid 2006, the momentum was easily quashed triggered by the global credit crisis in 2007.

You have to remember that the Phisix climbed from 2003-2006 by about 127% with daily trades drifting within a range. This supports the view that the Phisix has been gradually wended from the stealth phase to the awareness phase where buyers were mostly from “smart” money camp.

Thus, this implies that even before the Phisix bubble took off, it popped! The Phisix Bubble has effectively been deferred! Seen in a different light, this process should even be more beneficial to us, since it gives “smart” money a second major opportunity to build up on our portfolio to take advantage of depressed retail sentiment which should lengthen the bubble cycle and proffer marvelous opportunities of outsized profit returns!

No Evidence of Excess Leverage

Third, ALL bubbles are driven by excessive leverage from massive credit and or monetary expansion.

Think of the Phisix and the Asian crisis in 1997, 2000 Nasdaq dotcom bust, 1990 Japan’s stock market and real estate bubble bust, the US housing bust in 2006 and the commodity bust in 1980 to name a few. The common denominator has been a pyramid built on the walls of leverage.

As previously pointed out, we have very miniscule exposure of US mortgage related tainted papers which according to reports figures to only about .2% of the total banking assets.

We also have not seen material signs of ballooning credit or leverage in any of our macro and micro statistics yet (e.g. Real estate loans, stock margins, current account deficits, corporate loans, etc.).

Figure 4: IMF: Asset Price Developments (left), External Liabilities (right)

For instance, external liabilities as % of GDP has been falling drastically (see figure 4 right window), which means Philippine credit risk relative to foreign debts have considerably declined, albeit it remains to be seen how the recent “politicized” policies on the rice crisis will impact this.

However based on past performance this excerpt from the IMF,

`` External liabilities by Philippine residents (as measured by FDI liabilities, gross portfolio liabilities, and other liabilities—currency and deposits, as well as loans) have fallen sharply since 2004. Starting from a level above 90 percent of GDP, which was raising serious sustainability concerns, external liabilities had declined by over 20 percentage points of GDP by 2006. This sharp decline reflects the significant debt prepayments of the general government and corporate sectors (including the highly indebted power sector).”

`` This reduction is particularly stark in comparison with other countries. The Philippines was a clear outlier at the start of the decade. Since then, the Philippines’ total gross foreign liabilities (as a share of GDP) have converged rapidly to the levels of emerging Asia and emerging Latin America., and by 2006 had actually fallen slightly below the averages of both regional groups.”

The IMF in their April Staff report issued this statement (emphasis ours),

``There is no clear evidence of an emerging bubble. Partly reflecting developments in Asia, asset prices have bounced back. However, property prices are still below the 1997 level. Equity market prices have risen faster with the PE ratio reaching 15½ at end-2007. Equity prices have fallen by more than 10 percent during the first three weeks of 2008, now implying a PE ratio well below the worldwide average of 21 during 2001–06.”

So, there you have it…essentially for Philippine assets you have NO EUPHORIA, NO SPECULATIVE EXCESSES, NO OVERVALUATION and NO MASSIVE LEVERAGE! Ergo, NO BUBBLE!

The main market risk today comes mainly from domestic populist politics and from external variables or the transmission effects of a global economic slowdown which could lengthen the entire process but is unlikely reverse the present cycle unless a black swan occurs (possibly from US dollar crisis or global depression or world war).

Heeding Buffett’s Advise: Be Greedy When Others Are Fearful!

Thus we ask ourselves, how can we afford to be bearish when the cycle insinuates that we are still locked in a long term “advance” phase or a bullmarket? Not unless if our horizon is TOO SHORT, as to read in today’s action as an everlasting trend.

Dr. John P. Hussman, Ph.D. of the Hussman funds offers some sagacious advice, ``Good investments are those based not on hope, but on some foundation of evidence – either of reliable “investment merit” (based on properly normalized valuations), or of measurable “speculative merit” (based on the quality of market action). Taking a significant exposure to market risk without such foundations is like moving into a house built on sand.”

We should instead take a cue from the world’s best stock market investor and now the world wealthiest, billed as the sage of Omaha, Mr. Warren Buffett, who appears to have embarked on a buying spree following years of holding a war chest of over $40 billion.

In a lecture at Columbia University at age 21 Mr. Warren Buffett was quoted, ``I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."

Now that we have been seeing many worsening signs of fear, I think it is time to gradually take advantage of such opportunities.