prudent investor newsletters: Phisix: A Deeper Look at the Philippine and Indonesian Stock Market Mania

A Creeping Déjà vu of the February 2013 Mania

Well, actions in the Philippine stock exchange seem like a déjà vu of the manic phase of February to early March of 2013.

We uncannily see three similar traits. One, the slope in the uptrend of the Phisix has gone parabolic or ballistic. However as discussed last week[1] the time period and intensity covering this ascent has been variable.

Second, in the trading sessions of both February 28^th of 2013 and 2014 there had been a coincidental “marking the close”[2]—where the Phisix had been substantially pushed up at the closing bell by certain parties in what seems as an attempt to accomplish some unstated goals.

Third the interim correction cycle may have begun. The beginning date of 2013’s correction: March 11^th. In 2014, this corrective phase started in March 12^th.

Creepy coincidence no?

The Phisix closed the week off 1.4%. In 2013, the depth of the correction was 6%. Since the degree of ascent has been different, I doubt if depth of the interim correction will be similar.

So far history has rhymed.

And as I have been pointing out over the past two weeks, the reason for the seeming eerie resemblance has been out of the desperate attempt by the consensus to foist a resurrection of the old bullish environment characterized by the easy money ‘tailwind’ of zero bound rates, low bond yields, suppressed inflation and a strong peso—as against today’s relatively tighter money conditions via the headwinds of a weak peso, rising price inflation and elevated bond yields. Such ‘resistance-to-change’ attitude have brought about vehement price reactions via the frenzied bidding up of asset prices rationalized from the use of selective ‘positive’ economic data to justify such actions. Such impetuousness guarantees magnified volatility.

Unlike 2013, the 2014 version of correction has been distinct in the sense of net foreign buying support as against net foreign selling last year.

Every market transaction constitutes a buyer and a seller of a particular good, service, or a financial security for an agreed price and specific volume. In the context of the Philippine Stock Exchange, there is no such thing as a “money flow” in the trading of publicly listed securities.

So what the mainstream sees as “money flows” are really changes in the composition of ownership of securities. Thus the obverse side of every foreign buying is domestic selling and vice versa. Money is simply exchanged between the buyer and the seller of securities.

And the ensuing directional changes in price levels are determined by the dominant or prevailing sentiment.

These are economic and financial truisms and not merely interpretations. They are apodictic self-evident truths (in Austrian economics terminology: synthetic a priori propositions[3]).

This becomes interpretative when we inject adjectives like “bullish” or “bearish” in the imputations of actions.

For instance, despite net foreign buying which meant foreign demand for peso assets, this week’s decline of the peso vis-à-vis the US dollar from 44.38 to 44.655 (.6%), which basically negated last week’s rally, implies that demand for US dollars must have emanated from domestic sources. In my construal of events, foreign demand for peso assets has been more than offset by local demand for US dollars for the Peso to tumble. Thus it is not farfetched to posit that since some of such ‘overt’ optimism has not extrapolated into actions, some segments of the consensus may have used “bullishness” as a decoy to conceal their actual (selling) actions.

The Wall Street vernacular for this is “pump and dump”.

Given the current activities, where foreigners and retail accounts seem as the bullish participants based on market actions, I suspect some of local institutions as the net sellers of local stocks and have been net buyers of the US dollar.

Fugasi

The Indonesian Stock Market Bubble

In the current setting, ASEAN stock markets seem to have become a magnet for speculative foreign capital starved of yields, all justified from some mythical strength.

Based on last week’s action there has been an apparent shift in market volatility.

From June 2013 until February most of the financial tremors plagued emerging markets. This week the role switched. (I will deal with this later)

Nonetheless emerging Asia seems to be defying gravity. Anything with an ASEAN tag seemed to have been turned into gold as if touched by the magical hands of Greek mythological King Midas.

Indonesia’s equity benchmark the JCI skyrocketed last Friday by 3.23% to end the week up by an astounding 4.11%! According to news this has brought Indonesian stocks back into the “bull market”.

Why? Because a populist leader, Jakarta Governor Joko Widodo, is running for president.

Let us hear it from Bloomberg[4]:

A Widodo administration would probably boost spending on infrastructure and public welfare, CIMB Group Holdings Bhd wrote in a report last month. Indonesian shares have rallied this year as an acceleration in Southeast Asia’s largest economy, improving corporate earnings growth and the prospect of increased spending before national elections that start next month lure international investors. Foreign funds have poured $1.01 billion into the nation’s stocks so far in 2014.

Incredibly just about a few months a back, Indonesia was at a verge of a crisis.

I read one analyst effusively extolling on how Indonesia has been recovering (e.g. lower inflation, narrowing current account deficit and etc…) and of the great business environment they have been.

A half-filled glass can be seen as half-full or half-empty.

So I will simply show you what has been claimed as “recovery”.

Indonesia’s statistical inflation (top pane) has indeed slowed from a high of 8.79% to 7.75% but this still way up from 2013 lows.

Another much touted recovery has been the current account, while it is true that such deficit has been halved from the third quarter, the current levels are still above 2012.

The gains have been mentioned but not the losses.

Indonesia’s January trade balance has posted a deficit. Yet a weakening of trade balance will put pressure on the current account, which comprises of trade balance, net factor income and cash transfers.

And contributing to the weakening of Indonesia’s trade balance has been a sharp plunge in January exports that followed a December upside spike. So if the December data was an anomaly, then the January’s sharp decline could have merely neutralized such aberration. This could also mean that the halving of current account deficit in the last quarter may well be a one-off deviation caused by the December spike.

Yet outside the export spike in December, both export and import trends seem to be slowing. Such are hardly optimistic indicators of a healthy economy.

Besides even Indonesia’s statistical GDP seem as in a steady decline. From a high of the annualized growth of 6.9% in 2011, growth rate has gradually levelled off to 5.72% (4Q 2013) but slightly up 5.62% in the third quarter. This is recovery?

Indonesia’s merchandise trade, which has also been diminishing, accounts for 43.1% of her GDP as of 2012 according to World Bank.

And based on ING’s 2012 study[5], Indonesia’s top 5 export partners are (in pecking order) China, Japan, Singapore, South Korea and India. In terms of top 5 import partners, Singapore, China, South Korea, Japan and Thailand.

In short, Indonesia’s economy has been heavily leveraged to Asia which means she is highly sensitive to developments in the region.

A slowdown in China and Japan or the rest of Asia will materially affect Indonesia’s economy in terms of trading linkages. And I recently wrote about the substantial decline in exports—collapse (10%+) in Japan, China, Mexico, Russia and Brazil; sharp downdraft in South Korea; marginal declines in the Eurozone and the US—appear to be manifestations of sizeable downshift in the global economic growth[6].

Notice too that Indonesia’s slowing rate of economic growth seems synchronous with the decline in the contribution of her merchandise trade.

And here is where it gets interesting.

Indonesia’s government budget deficit as % of GDP, which has been drifting between .5 to 1.5% from 2008 to date, have been estimated at 2.02% in 2014[7]. Notice that nominal deficit (in euro) [right window] has been cascading down but “strong” statistical economic figures offset such declines when viewed from % of GDP. This looks very much like the Philippines, but I will deal with this later.

The interesting part is exactly the paradox of what the market has been cheering at—government spending. The new government is expected to be spending a lot of money for political projects.

Currently, projected infrastructure spending for 2014 has been at $39 billion[8], so perhaps political entrepreneurs (euphemism for cronies) may be leaping for joy that the new government may divert MORE resources that will accrue to their benefit at the expense of the economy.

But aside from this, the Indonesian government has an existing major problem: SUBSIDIES.

Despite reduced upside volatility in oil prices, the 2013 depreciation of the rupiah have ballooned the cost of subsidies by more than 25% to $25 billion according to a Societe Generale study as noted by Investing.com. This will now consume about 20.9% of government revenues compared to just 14.5% in 2006. In addition, as net oil importer since 2004, oil imports will likewise swelled to a record $63.5 billion in 2018 from $40.4 billion today[9]. So oil subsidies and imports will put pressure on government budgets.

There is no free lunch. Where will the Indonesian government get financing for these?

In order to finance the welfare-infrastructure spending binge, the Indonesian government has already undertaken measures to raise a record IDR 357.96 trillion (USD $29 billion) in international and local bond markets in 2014 as I previously noted[10].

So aside from the rupiah’s depreciation in 2013, higher bond yields will translate to higher costs of servicing debt. Aside the only meaningful act undertaken by the government has been to raise official interest rates by 198 basis points in the second semester of 2014

So how will higher interest rates (or still elevated inflation rates) translate to “improving corporate earnings growth” and higher demand for the economy?

The Indonesian economy has been ramping up on her foreign dollar liabilities. While external debt has increased by 5% in 2013, CAGR from 2009 has been at 8.84%. Private sector debt has inflated by 13.81% as against 4.47% by the government. In breaking down the distribution, for 2013 overall external debt has been 47% government and 53% private sector[11].

And given the increased costs of subsidies and debt servicing of foreign claims, I think such statistics understate real credit activities.

And the stock market has celebration has barely been enthusiastically shared by the rupiah and her 10 year bond yields (in terms of degree), despite the recent rallies of the latter two.

The Pollyannaish analyst also wrote that Indonesia is a nice place to do business. Yet Indonesia has recently imposed “natural resource protectionism/nationalism” by the banning exports of ore products. The new administration is seen as maintaining a tough stance towards mineral exports[12]. Protectionism reduces economic activities. How will limiting economic activities extrapolate to economic growth?

Additionally the Indonesian government has imposed massive minimum wage increases anywhere from 10% to 222% applied distinctly for specific provinces in 2014[13]. I would estimate the median to be at 25%. I cited this last November[14]. How will forcing companies to increase business costs via minimum wages increase profits enough to attract business investments?

Moreover business groups like the European Chamber of Commerce have been appealing to the government to intensively ease of business regulations[15]. Such are symptoms of economic repression.

The Indonesian Property Bubble

Finally in 2013 I mentioned that Indonesian economy has been nurturing a bubble[16]. It appears that Indonesia’s property bubble has inflated large enough to be acknowledged by the mainstream.

Fitch ratings warned last week that Indonesia’s property bubble, which has been sizzling for the “past three years”, has been undermining bank conditions due to the proliferation of low quality special mention loans (SML). Due to deterioration of SMLs, Indonesia’s non performing loans (NPL) has reportedly been on the rise[17].

Notice that without NPLs, bubbles as expressed by rapidly surging prices financed by an explosion of credit won’t be seen by the credit rating company. You can see Indonesia’s skyrocketing residential property prices (as of March 2013) here.

The Oxford Business group likewise notes that due to increased regulations to curtail on the spiraling loan mortgages such as the “lowering of the maximum loan-to-value (LTV)” and “a new rule that prohibits banks from providing loans for unfinished residential projects”, property prices has been expected to rise by just 10% in 2014 “compared to an average of 15-17% in recent years”. Remember Indonesia’s economy has been growing by about 5-6% so property prices have been growing thrice the pace of the economy.

The group also noted that according to Bank Indonesia’s July figures, “outstanding mortgages on apartments measuring 22-70 sq metres surged 57.2% year-on-year.”[18]

Indonesia’s loans to the private sector have stunningly expanded by about triple today from 2008. Such explosion of loan growth has been transmitted through money supply growth where M2 has more than doubled over the same period. So this has been the primary cause of the surge in Indonesia’s price inflation and hardly about the earlier partial lifting of subsidies or about the Fed’s taper.

So despite the recent interest rate increases, there has been so much excess money in Indonesia looking for yields to chase at. And part of this has been the fight to reclaim yesterday’s easy money environment through the rekindling of Indonesia’s stock market bubble and the further escalation of her property bubbles.

With all the money being thrown into speculative activities, it is obvious that whatever gains achieved over the last few months have been temporary. Reasons? A surge in demand for credit will mean higher interest rates. Credit financed spending will extrapolate to relative price inflation that will mean higher bond yields and eventually higher interest rates.

And more, perhaps in sensing the narrowing spectrum of assets producing positive yields foreign money have been forcing to bid up on ASEAN assets, by conjuring myths about the sustainability of bubble economies—in apparent flagrant disregard to the various risks.

And here are more disturbing signs of the deepening mania. Prior to Friday’s bullish rampage, a report from Reuters notes that “consensus PE ratio for Indonesia is 26.3 percent above its long-term average”. Given Friday’s 3.23% surge, this would entail Indonesian PE ratios at the firmament.

Indonesian equities have also a very pricey book value, “The rally has made Indonesia one of Asia's most expensive markets, with a price to book ratio (P/B) of 3.5.” Guess who comes next? “The Philippines comes closest to that kind of valuation with a P/B ratio of 3.”[19]

In short, Indonesian equities have been trading at the fat tail end of the probability distribution curve. Yet like the Philippines, these punters see such aberrations as the new normal.

And like the Philippines, the real reason why governments promote the quasi permanent inflationary boom is to have access to money (via credit markets and taxes) to support their pet projects. And proof of this is that global debt, according to the Bank of International Settlements have ballooned to $100 trillion or a $30 trillion or a 42% increase from 2007 to 2013 due mostly to government spending[20]. Such colossal diversion of resources is why the world is now faced with a clear and present danger of a Black Swan economic and financial phenomenon.

Or perhaps as the late singer Tupac Shakur said, Reality is wrong. Dreams are for real.

Does Moody’s have a Clue?

Going back to the Philippines.

Another source of economic fiction is the claim by rating company Moody’s that the Philippines won’t be hurt by a sudden stop because “The Philippines’ household debt-to-GDP ratio is among the lowest across Asia”[21].

This is a prime example of interpreting statistics in the pretense of talking economics or economic risk analysis

First of all, the “sudden stop” has yet to occur. But Philippine markets have already responded violently with three and a half incidences of bear market strikes, the continuing slump in the peso and elevated bond yields. These are market signals that have real economic effects.

While the market turbulence hasn’t percolated significantly into the real economy (yet) it doesn’t mean that just because it hasn’t happened, it won’t happen. This signifies a cognitive fallacy called anchoring. Once the big storm truly arrives, let see how immune the Philippines will be. And it is coming.

Second, the Philippines’ household debt-to-GDP ratio is a non-sequitur. Moody’s people see ASEAN economies wearing a “one-size-fits-all” T-shirt. This isn’t economics. This is stereotyping.

Third, the Philippines have a different debt dynamic than Indonesia, Thailand or Malaysia.

In the knowledge that there are only 2 out of 10 households whom are enrolled in the formal banking system, how on earth can 20% (or less) of the overall Philippine household carry a debt load of the equivalent of Thailand and Malaysia with far larger formal sector participation? This is mistaking unique-specific dynamics or “case probability” with frequency or “class probability”[22].

Instead the Philippines debt dynamic has been weighted on its finance and non-finance sector rather than the households. The World Bank has a great chart of the difference in the debt profile of ASEAN and China. See graph here.

Officials at Moody’s seem to be looking at the wrong picture.

This also means Moody’s has seriously been underestimating risks of the Philippines.

Has Moody’s seen the debt profile of publicly listed San Miguel Corporation[23]? SMC seems embroiled deeply in both short term and long term debt. The long term debt is what the public sees.

Yet SMC rolls in and out short term debt to the tune of 200 to 250 billion pesos per quarter (and growing). And SMC appears as hardly earning enough to support the amount she owes in interest and principal. In a credit event, all liabilities (short term and long term) will surface.

Has Moody’s seen that in three quarters SMC’s short term debt rollover has accrued nearly 10% of the resources of the Philippine banking system? SMC says that these short term loans are mostly sourced from the banking system, should a SMC credit event occur will the Philippine banking system be immune?

The reason why SMC can play the musical chair game of debt in and debt out is due to zero bound rates and a strong peso. But there has been widening of cracks in the easy money scenario from which her unsustainable debt conditions depend on.

Does Moody’s have a clue?

Has Moody’s also checked with Bangko Sentral ng Pilipinas (BSP), and asked why the Philippine central bank has kept a blind eye on her self-imposed 20% loan limit to banking system’s loans to the real estate sector? The real estate loan cap as % to total loans have been breached in May of 2013, yet in November the ratio has ballooned by 10% to 22%[24]. Still no actions from the BSP, why?

To consider, the real estate industry has announced an expansion of a conservative Php 250 billion, most of these will come from loans.

Who will provide financing for these companies? They are likely to be sourced from domestic banks, shadow banks, offshore banks, domestic bond markets or foreign bond markets. If sourced through the banking system, will the real estate banking loans hit 24% of total loans in April 2014?

What are the risks of acquiring loans from the other non-domestic banking sources? How are they connected with banks? What will be the effects of the real estate spending spree on the prices, not only of properties but of goods and services of the industries supporting the property boom? How will these prices affect the balance of supply and demand of these goods and services and vice versa?

Does Moody’s have a clue?

Has Moody’s also inquired with the BSP on why the domestic money aggregates has grown by 38.6% in January despite repeated official assurances for its decline?? Does Moody’s know that 68% of M2 growth emanates from domestic claims on both the non-finance and financial segments of the private sector? What are the risks of a sustained 15 to 30+++% money supply growth to the economy and to the banking system?

Does Moody’s have a clue?

How about corporate debt? The chart above from the IMF[25] reveals that based on corporate debt-to-equity ratio, compared to ASEAN neighbors, only the Philippines in 2012 has surpassed the 1998 (Asian crisis) levels of the said ratio.

Yet as I recently pointed out citing Deutsche Bank data, a few domestic corporations has resorted to increasing intensity of borrowing through US dollar denominated bonds in 2013[26], thus the concentration of risks.

And how about Philippine debt acquired (loans by nationality) via offshore banks and international bond markets? Based on Bank of America Merrill Lynch data as I previously noted, “While the Philippines have the least exposure in nominal US dollar based loans, at 4.34x (!) the Philippines has the 2nd biggest growth rate after Thailand.”[27]

What are the potential risks from debt acquired these channels? How are they related to the banking system and to the economy?

Does Moody’s have a clue?

The late American physicist Richard Feynman in a commencement address[28] gave a wonderful advice that should be heeded by all

The first principle is that you must not fool yourself—and you are the easiest person to fool. So you have to be very careful about that.

Phisix’s Price Earnings Bubble

And let me get back at the outrageous mispricing of Philippine stocks.

I have an update that covers the entire Phisix index

As of Friday’s close the Phisix carries an average PE ratio of 22, based on 2013 earnings, and 25.31 based on the average 4 years. Anyway both are materially overvalued.

But it would be a mistake to treat the PSE’s PE ratio as an aggregate for the simple reason that price changes or returns for each issue have been dissimilar.

So for instance, it would signify a baseline error to suggest that based on 2013 earnings, a pullback by the Phisix to 5,557.6 from Friday’s 6,391.24 would pare the PE ratio to 15 will effectively reduce her froth. That’s because it must be understood that the overpriced PE ratio of the Phisix has been a function of the suppression of the PE ratio by the underperformance of the low PE ratios.

In the above table I show both the 5 highest and lowest pe ratios of the Phisix members based on Friday’s closing prices divided by the average eps over the past 4 years.

The 4 year compounded annualized growth rates of the above firms exhibit the variability in the performance between high pe ratio Phisix stocks and low PE ratio stocks. In other words, what has driven the Phisix to the current levels has been the dramatic overdrive of issues that led to their significantly high pe levels. This means that for the Phisix to return to any semblance of “value”, such high pe ratio stocks would need to retrench most of their frothy gains.

As one would note while the Phisix only posted an 8.82% cagr from 2010-13, URC and ICT has generated 3.87x and 2.57x the Phisix. Yet one can’t isolate the URC and ICT because their respective returns helped produced the 8.82% annualized gains by the Phisix. Meanwhile the lowest PE has severely underperformed or even generated negative returns. Thus what seems as a suppressed PE.

What has been more interesting is the relationship between the 4-year compounded annualized returns and the 4 year compounded eps growth by the highest PE ratio companies. The return/ eps growth represents the stock market gains for every eps growth generated. In terms of URC the market has been paying Php 6.22 for every peso growth generated by the company and so forth.

The more I examine the valuation of Philippine stocks particularly of the popular issues, the more I come into the conclusion that current market has embraced delusions of grandeur.

And from the financial valuations perspective how does the PE cycle evolve?

Well according to Ed Easterling of the Crestmont Research it’s all based on inflation[29]. (bold mine)

What drives the P/E cycle? The answer is the inflation rate—the loss of purchasing power of money and capital. During periods of higher inflation, investors want a higher rate of return to compensate for inflation. To get a higher rate of return from stocks, investors pay a lower price for the future earnings (i.e. lower P/Es). Therefore, higher inflation leads to lower P/Es and declining inflation leads to higher P/Es.

The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings (the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.

During stagflation, which has been a progressing case in the Philippines[30] and in Indonesia as shown above, such environment should theoretically lead to declining stocks from the prospects of lower PE brought about by higher inflation. But of course, the consensus whom has been inured (or may I say addicted) to central bank implied guarantees on high roller bets, have been resisting such an environment, thus continues to bid up on stocks financed by credit. The end result should be a Wile E. Coyote moment or a bubble bust or price deflation, which also means declining PE.

In the US the PE cycle has traded typically from “below 10 times earnings to levels above 20”. But during bubble periods, PE ratios “tends to peak near 25” remarked Mr. Easterling.

It seems that whether in the US or in ASEAN, we definitely see Price Earnings Bubbles.

As a side note, it is so interesting to see how Philippine authorities and media continue to be flummoxed by the high rate of joblessness and stubborn poverty levels[31]. Yet the same authorities and their experts suggest for more of the same factors causing them via “safety nets” and via proposals to close “the mismatch of skills”.

Will the extension of schooling by the Philippine government to 13 years solve this[32]? I won’t bet on it. But there is one thing I will bet on, big league schools will be the primary beneficiaries from the mandated years of forced extended education at the expense of their pupils who should be acquiring real education via working experience than from the blackboard[33] and from pseudo school sanctioned internships. It is already sad to see that as of 2010, 2/5 of graduates have been unemployed. Yet mandated blackboard education and simulated internships will lead to more job-skill mismatches and more unemployment.

[1] See Phisix: The Stock Market Mania Deepens March 10, 2014

[2] See Phisix: Why Tomorrow’s Fundamentals will be Distinct from Yesterday March 3, 2014

[3] Hans Hermann Hoppe PRAXEOLOGY AND ECONOMIC SCIENCE Economic Science and the Austrian Method Mises.org

[4] Bloomberg.com Indonesia Stocks Enter Bull Market on Widodo’s Presidential Bid March 14, 2014

[5] 2012 Indonesia ING International Trade Study

[6] See EM Contagion: Based on Exports, Global Economic Growth appears to be Downshifting Fast March 12, 2014

[7] Asian News Net Indonesia's budget deficit in 2014 estimated to reach 2.02 per cent September 17, 2013

[8] Jakarta Globe Indonesia’s Infrastructure Spending Projected to Reach $39 Billion in 2014, January 10, 2014

[9] International Business Times What Indonesia's Fuel Subsidy Is Costing March 14, 2014 Investing.com

[10] see ASEAN Crisis Watch: Indonesia’s bond market selloff accelerates January 28, 2014

[11] Bank Indonesia External Debt Statistics of Indonesia February 2014

[12] Reuters.com Indonesia's next leader unlikely to ease tough mineral export rules March 11, 2014