prudent investor newsletters: Phisix: The Correction Cycle is in Motion

Monday, August 27, 2012

Phisix: The Correction Cycle is in Motion

The correction phase of the Phisix has become more evident.

Reversion to the Mean: Convergent Market Breadth and Technical Picture

Technical actions and domestic market internals seem to self-reinforce the ongoing cyclical dynamic.

First of all, a technical indicator suggests of a bearish pattern called the head-and-shoulders[1] where a breach of the 5,125 support could mean a test of the major support level at the 4,800 (or from a technical perspective the Phisix may even fall to 4,700).

While I am not a fan of technical charting, I do use it in the understanding that there are many practitioners of these. This implies that critical break points may lead to self-fulfilling momentum swings, albeit the impact could be on a short-term basis. Technical targets often miss.

Anyway, the principle of charting feeds on the pattern seeking behavior or cognitive biases inherent in people than from the more important scientific understanding of human action.

Second, developments in the market internals seem to chime with current chart dynamics.

When the impeachment trial of former Chief Justice of the Supreme Court concluded last May, I laid down my suspicions over the probable political interventions to prop up the Phisix. That’s because during certain periods last June, the Phisix strikingly defied major developments abroad. Amidst hemorrhaging global markets, the Phisix had a huge intraday swing from big losses to substantial gains.

I wrote[2],

The point is ‘interventions’ will eventually be smoothed out or neutralized by the underlying forces which drives the financial markets.

Such interventions had hardly been a one-time event. A deluge of popular self-congratulations over the supposed political accomplishment and mainstream media halleluiahs rationalized the accompanying euphoria in the Phisix.

Nearly a quarter after, circumstantial evidence appear to validate my hunches

The bullish market breadth as measured by the advance-decline spread peaked last January. This has not been surpassed by the recent rally, which ironically brought the local benchmark to a milestone all-time high.

This only means that the June-July rally had been mostly “concentrated” to major heavy cap issues that had large influence in the fluctuations of the local benchmark.

When the market is broadly sanguine, people are willing to take on more risk, thus, the tendency has been to accelerate trading activities.

That supposedly boisterous (politically based) bullish outlook has not matched with the July record setting high of the Phisix.

The same divergence has been exhibited in the number of daily trades (averaged weekly).

In other words, the record breaking rally last June-July has not improved the risk appetite of the median investor as aggressive trading apparently topped out last March.

Again when the market is generally confident, the increase in trading activities will similarly be manifested on the number of issues traded.

Has there been broad market bullishness here?

Nope. Media and popular blarney was not evident in real action.

The same story can be seen. Another divergence emerged, the total number of issues traded daily (averaged weekly) reveals that bullish market sentiment crested on March. The July landmark of the Phisix has not been reinforced by broad market gains.

From the picture based on the market breadth, the record Phisix in the face of divergences meant that correction became imminent. This is what we are encountering today. It simply shows of the forces of “reversion to the mean[3]” at work where artificial price levels supposedly revert to the average.

Oh, to add, the bear market in the Mining sector, which for me, signified as the proverbial shot across the bow for the imminent correction of the Phisix has partly been confirmed.

Then I wrote[4],

I lean on condition (B) or where the bear market of the mining sector will likely percolate into the general market, due to growing risks of contagion

For the holiday abbreviated week (which will be extended for the coming week), only the service sector has posted positive returns. All other sectors including the Phisix fell.

And in looking at the price actions of the different industries, this year’s biggest gainers; the property (violet), banking and finance (black candle) and holding (teal), including the Commercial Industrial sector (blue) have all exhibited signs of rolling over.

After a major selloff, the mining index (light orange) seems to be probing for a bottom.

Again, it is only the service sector (red), which has been this year’s second laggard after the mines, that has showed some signs of resiliency. But my guess is that the current correction cycle will be broad based.

The abovementioned divergences are in fact signs of distribution—where gains over the market have been narrowing. Again technical actions (chart patterns and broad sector activities) seem to reinforce this cycle. In short, previous divergences appear to be converging through a retrenchment phase.

The interventionists, whoever they maybe, managed to push up the Phisix by less than 5% in two months. Now and in the coming sessions, whatever gains they have accrued will likely be eroded if not entirely expunged.

As I have repeatedly been pointing out, the impact of financial market interventions tend to be short term.

Yet the clear lesson that can be gleaned from the above is that People’s action speaks louder than verbal “feel-good” but senseless utterance.

In the theory of human action this is called demonstrated or selected preference.

Central bankers have Rigged the Capital Markets

Of course, I keep emphasizing that the interim gyrations will depend on external developments, particularly from the US.

Even as the current domestic environment operates on bubble policies, the extent of misallocations of capital has not yet reached cataclysmic bubble proportions.

We are more prone to the risks of contagion.

Except for a few standouts, most of the major markets traded lower this week.

Except for blazing hot Thailand, for the rest of the ASEAN giants, the Phisix (PCOMP-red) along with Indonesian (JCI green) and Malaysian (FBMKLCI orange) bellwethers also seem to be topping out.

That should be natural considering the he unfolding developments in China which for me remains as a big concern.

The ballooning number of unsold goods[5], hot money outflows and worsening manufacturing activities[6] among many other economic indicators seem to be worsening and exhibiting signs of a “hard landing”.

A China hard landing or a recession which will likely involve a debt or financial crisis, which will most likely affect commodity exporters and the Asian supply chain network.

Moreover, the slew of negative economic developments has also been manifested in Friday’s breakdown of the Shanghai Index. This should be taken seriously.

China’s major bellwether has so far been in a slow motion decline. Where fear is the most powerful of human emotion[7], slomo can transform into panic in snap of a finger.

For the US and Europe, markets remained transfixed on the central bank actions with special attention over this weekend’s Jackson Hole meeting[8].

Friday’s substantial rally in US stock markets which mitigated the week’s losses, the first loss in 6 weeks, shows of deepening expectations of central banking rescue. From a Bloomberg article[9]:

U.S. stocks rose, paring the first weekly decline in almost two months for the Standard & Poor’s 500 Index, as Federal Reserve Chairman Ben S. Bernanke said he saw “scope for further action,” increasing speculation the central bank will act to boost economic growth.

Again this has been no different in Europe, where financial markets seem to seek for an escape mechanism for their real world problems with the narcotic effects from central bank policies. From another Bloomberg article[10]:

European stocks were little changed, with the Stoxx Europe 600 Index posting its first weekly drop since June, as German Chancellor Angela Merkel said Greece must stick to its commitments to stay in the euro area, and a news report said the European Central Bank is considering setting yield band targets.

Stock markets have been transformed into a game of anticipation on the prospective actions of central banks. It’s a game tilted towards politically connected insiders where the central bankers have effectively rigged the capital markets.

Audit the Fed and President Obama’s Re-election

US equities, for me, seem to have greater downside risk, considering developments abroad prompted for by dilly dallying central bankers and of seeming interminable political wrangling. That’s my bias based on my past analysis[11] [12].

However, given the effective politicization of financial markets, it would be a mistake to discount that US stocks may be manipulated to advance President Obama’s re-election goals[13].

The performance of the stock market have been said to have some influence on or connections to the outcome of US Presidential elections.

According to FoxNews[14],

Of the 28 presidential elections since 1900, an improvement in the S&P 500 prior to an election preceded an incumbent victory 80% of the time, or 16 of 20 of times. The S&P 500’s direction during that period carried an accuracy rate of 82%, according to S&P Capital IQ data.

“Either we have a tremendous situation of being fooled by randomness or we have an interesting stock market phenomenon,” said Sam Stovall, chief equity strategist at S&P Capital IQ.

Of the three out of the four times the incumbent lost following an S&P 500 upswing, outside factors such as third-party candidates were involved, like when Teddy Roosevelt created his own conservative political party ahead of the 1912 election, taking away votes from incumbent William Howard Taft and ultimately leading to the election of Democrat Woodrow Wilson.

When the market fell ahead of a presidential election, the incumbent was overthrown 88% of the time. The only time this predictor failed was in 1956, when Adalai Stevenson failed to overthrow incumbent President Dwight Eisenhower, which could have been a reflection of macro political pressures such as the Suez Canal crisis or Soviet headaches.

This may be coincidence. But advancing stock markets, perhaps, could be interpreted by the public as “progress” even when gains are manipulated or boosted artificially by bank credit expansion.

Besides, policymakers see stock markets as barometer for the animal spirits or market confidence. In the past, US Federal Reserve Chairman Ben Bernanke as an academic professor wrote that

History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

This is what I call as the Bernanke dogma. As proof that such dogma has been used as a major tool in today’s policymaking, recently the New York Federal Reserve even boasted of having successfully pushed up US Stock Markets[15].

The Bank of England recently admitted that their Quantitative Easing policies boosted asset prices of mostly the rich[16].

The Bernanke doctrine incorporates not only saving the stock market but of the other financial markets as well, through what he calls as financial accelerator

In a 2007 speech, Chairman Bernanke expounded on what he sees as the importance of keeping financial assets afloat[17]

financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission

The above underscores the academic justifications of central bank interventions. Also one cannot ignore that policy interventions can be timed to attain political goals.

Also considering that President Obama’s opponent, Mitt Romney, has piggybacked on Ron Paul initiative to have the US Federal Reserve audited[18], which thereby diminishes the political power of Ben Bernanke, we cannot rule out that Mr. Bernanke will use the banking system and the Fed’s monetary tools to ensure Obama’s re-election.

So far, in terms of growth of monetary aggregate, M2 has been on a decline but has now reached at a nominal record high.

The chart of the S&P shows of two contrasting patterns: a bullish rounded bottom (lower green arc) and a seeming double top (two upper green arcs).

So US markets and the economy seem both mixed to neutral for now.

Commodity Rally and the Risk of Stagflation

Current environment has not been about consumer price inflation or deflation. Focusing on these manifests of confused perception of what has been happening.

Instead the current environment has been about deflating bubbles and of the monetary inflation responses from central banks. The articles quoted above are clear manifestations of such dynamics.

Consumer price inflation signifies as one of the symptoms of monetary inflation. Yet bubble cycles can occur with or without excessive consumer price inflations.

As the great dean of the Austrian school of economics, Murray N. Rothbard wrote[19],

if new money is created via bank loans to business, as much of it is, the money inevitably distorts the pattern of productive investments. The fundamental insight of the "Austrian," or Misesian, theory of the business cycle is that monetary inflation via loans to business causes over-investment in capital goods, especially in such areas as construction, long-term investments, machine tools, and industrial commodities. On the other hand, there is a relative underinvestment in consumer goods industries. And since stock prices and real-estate prices are titles to capital goods, there tends as well to be an excessive boom in the stock and real-estate markets. It is not necessary for consumer prices to go up, and therefore to register as price inflation.

The bubble dynamics of Thailand in the 90s demonstrates that booms may not necessarily be accompanied by strong surges in consumer price inflation. When the Asian crisis emerged as exhibited by the collapse of the SET[20], Thailand’s CPI fell close to zero[21]. No CPI inflation or deflation here. But a bubble occurred.

A significant development over the past two weeks has been the resurgence of gold.

The price of gold has made a critical breakout from the one year consolidation phase which came along with significant upside moves from the broader commodity sphere.

The recent rally by gold has been backed by the major bellwether the CRB, the industrial metals ($GYX) and energy ($GJX), as well as, the frontrunning agriculture ($GKX) indices. The latter has been catalysed by the US drought and worsened by the distortions from the policies aimed at the promotion of ethanol and biofuel energy.

As Cumberland Advisor’s Bill Witherell points out[22],

The US is projected to divert about 40% of its corn crop into ethanol, and about 60% of Europe's rapeseed crop goes to the production of biodiesel. Brazilian ethanol production consumes half of their sugarcane crop.

I would suspect that these belated moves by commodities have been prompted by the same expectations that have driven the recent stock market rally.

But instead of the constant toggling from risk ON to risk OFF environment, this may seem more of a rotational process or of the relative impact of monetary inflation to the economy. Oh yes, this seems hardly been about fear….yet.

It is yet unclear if the recent gains by commodities will be sustained. These will heavily depend on the actions of policymakers of the developed world and of China.

A recovery of commodity prices should eventually put a floor on the Philippine mining sector.

We should remember that the commodity bull run over the last decade, has largely been a function of insurance against monetary disorder, asset diversification and a position on emerging market development.

Yet current rally may be more about the insurance aspect as China’s economy seems to be stagnating.

It is also unclear if a sustained recovery in commodities will accompany a RISK ON environment for emerging markets and Philippines.

High commodity prices are likely to influence emerging markets consumer price inflation more. Food makes up a large segment of consumption basket for emerging Asia including the Philippines. This would prompt for their respective central banks to reluctantly tighten. Monetary tightening will put pressure on the stock market.

Stagflation, thus, also represents both a contagion and internal (political and market) risk for the Philippines and for emerging Asia[23].

Yet the divergence in policy rates between emerging markets and developed economies may induce more commodity inflation which eventually could be transmitted to developed economies.

Under this environment, positions on resource companies would be more ideal than to hold cash.

And should a stagflationary environment escalate around the world, do expect more pressures on the debt laden developed nations to default as the cost of interest payments on current liabilities soar. And any inflationist response from central banks, to drive down rates, would likely backfire and even worsen the situation.

I might add that if the US economy faces imminent risks of recession, it is likely that the US Federal Reserve will engage in more balance sheet expansion to bailout by reflating the system, this may fire up consumer inflation.

In the US, signs of consumer price inflation have begun to emerge from a combination of reasons. Peter Luger Steak house[24] expects to increase prices of their products based on higher commodity prices. Papa John’s Pizza will raise prices due to compliance on Obamacare[25], so has Chipotle Mexican Grill Inc., McDonald's Corp. and Buffalo Wild Wings[26]

Maintain a Defensive Posture

For now, do expect the Phisix to playout the normal and ‘healthy’ correction phase unless external events deteriorate more than expected.

There will be interim sporadic rebounds but unless we see improvements on both domestic actions and external conditions, we should remain defensive.

Playing defensive means patient positioning. Current events should extrapolate to a buyer’s market.

In the interim, we need to monitor the conditions in China, as well as, watch over feedback loop between the responses of the G-7 policymakers (as well as China) and of the market’s impact on them.

This only means that events remain highly fluid and susceptible to sharp volatilities.

Also, if the commodity rebound will be sustained, then the beacon of an impending bottom of mining sector should be in the horizon.

[1] StockCharts.com Head and Shoulders Top (Reversal) - ChartSchool

[2] See Phisix: Will the Risk ON Environment be Sustainable?, June 24, 2012

[3] Investopedia.com Mean Reversion

[4] See Philippine Mining Index: Will The Divergences Last? August 13, 2012

[5] see China’s Mounting Glut of Unsold Goods, August 24, 2012

[6] see China’s Manufacturing Slump Deepens August 23, 2012

[7] see Why Not to Pay Heed to the Prophets of Ecological Apocalypse August 21, 2012

[8] US Federal Reserve What's Next

[9] Bloomberg.com U.S. Stocks Rise As Fed Sees ‘Scope For Further Action’ August 25, 2012

[10] Bloomberg.com European Stocks Little Changed; Stoxx 600 Falls On Week August 24, 2012