Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets

Here is more proof that stock markets around the world have been mainly propped up by inflation (bank credit expansion)

If you recall, we earlier noted that the stock market of Bangladesh (Dhaka Index) posted as the second best performer in the world in 2010 gaining nearly 83%.

Chart from Bloomberg

Yesterday fortunes seem to have reversed, as the Dhaka index suffered a record crash. This provoked street riots and prompted for the forced closure of the exchange.

Picture from Marketwatch.com

According to Sify News

Stock exchanges in Bangladesh were forced to close down for the day Monday after share prices registered their biggest fall ever and investors took to the streets.

Angry investors vandalised some vehicles and set fire to tyres as they demonstrated in Motijheel area in the heart of the national capital.

People have been lured by easy money where “over three million people - many of them small-scale individual investors” had been affected by the crash, according to a BBC report. A crash reportedly brought upon by a “series of measures” implemented by authorities to restrain “overvaluation”.

Here is a short BBC report…

The series of measures involved the raising of the cash reserve requirements for banks…

From AFP

On December 15, the Bangladesh Bank had raised the cash reserve requirement (CRR) by 50 basis points, tightening money supply in a bid to rein in soaring inflation.

Analysts, protesters and the SEC say this is what triggered the collapse as some banks, which had invested heavily in the market, tried to offload their shares quickly in an attempt to meet the new requirements.

and the curtailment of industrial loans that was being diverted into the stock market.

From Sify news

The limit for giving loans by the banks to their subsidiary companies was set at 15 percent of their total capital, but many banks invested more than the threshold only to increase their stakes in the capital market. BB had earlier directed the banks that invested more than the ceiling to adjust the excess amount by December 31.

Also, the central bank set January 15 as the deadline for the banks to recover loans taken by borrowers as industrial credit but were diverted into the share market.

And as Austrian economist Fritz Machlup correctly postulated

``If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, a boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted, since even a large supply is ultimately limited. The supply of funds derived solely from current new savings and current amortization allowances is fairly inelastic, and optimism about the development of security prices would promptly lead to a "tightening" on the credit market, and the cessation of speculation "for the rise." There would thus be no chains of speculative transactions and the limited amount of credit available would pass into production without delay.”

Bank credit expansion plus retail investor euphoria seem as prima facie evidence of the Boom Bust cycles brought about by easy money policies.

Evidence of Liquidity Boom: "The Market Loves Trash"

As we've been saying all along the global markets have been liquidity driven more than "fundamentally" driven.

This phenomenon seems evident including in the US, where small cap stocks have outperformed the big cap stocks.



From the Wall Street Journal, (Thanks to Bespoke for the pointer) [bold emphasis mine]

``After a brief swoon in January and early February, the riskier end of the stock market is back in favor.

``That includes small stocks, stocks badly hurt by the financial crisis and those most dependent on global economic growth. Safer stocks, including those that offer steady dividends, are out.

``That wasn't the case between Jan. 19 and Feb. 8, when the Dow Jones Industrial Average fell 8% amid fears that the global recovery could stall.

``Since then, the Dow is up 7%. And in most cases, investors are turning to the same stocks that led the market higher in last year's big rally.

"It seems like the lower-quality, smaller-sized names are taking the lead," says Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "We are getting a junk dominance again."

``By a variety of measures, lower-quality stocks are out-gaining higher-quality stocks, says Paul Hickey, co-founder of Bespoke Investment Group in Harrison, N.Y.

"In the words of Oscar the Grouch," says Mr. Hickey, "the market 'loves trash.' "

``He has ranked the quality of stocks in the Standard & Poor's 500-stock index based on their market size, price/earnings ratio and credit rating. He even sorted them based on which get the most attention from short sellers, the bearish investors who bet that stocks will decline by borrowing the stocks and selling them.

"No matter how you look at it, so-called low-quality stocks in the S&P 500 have outperformed high-quality stocks" since Feb. 8, Mr. Hickey says.

``The 50 smallest S&P stocks have risen 13%, compared with a gain of 9% for the 50 largest stocks. Companies whose bonds are rated as junk have risen more than those with investment-grade ratings. The 50 stocks with the highest prices, compared with analysts' expectations for their 2010 profits, are up 16%. Those with the lowest price-to-earnings ratios are up 10%. The most heavily shorted are up 15%. The least-shorted are up 7%."

My comment:

Essentially the outperformance of small stocks appear to be driven by momentum, as punters pile in on the winners in the expectations of continued strength.

As we previously pointed in Are Stock Market Prices Driven By Earnings or Inflation?, a refresher on some of the valuable insights of Fritz Machlup on the stock market.

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Extensive and lasting stock speculation by the general public thrives only on abundant credit.

Jeremy Grantham: Lessons Learned in the Decade

Here is a collection of insights by GMO's Jeremy Grantham from his latest outlook where he lists of the harsh lessons learned during the last decade.

Lessons Learned in the Decade: (Grantham in bold highlights) [comments mine]

-The Fed wields even more financial influence than we thought.

[This is nothing new. Mr. Grantham hasn't learned from 7th US President Andrew Jackson who caused the bankruptcy the Second National Bank of the United States. As per President Jackson, “Money is power, and in that government which pays all the public officers of the states will all political power be substantially concentrated.”]

-Low rates have a more powerful effect on driving financial assets than on driving the economy.

[The Austrians have been saying this long long long time ago.]

-The Fed is capable of being extremely out of touch with the real world – “what housing bubble?” – plus more doctrinaire – “no, the low rates had no effect on housing” – than anyone could have imagined.

[It's called delusions of grandeur, or as per Friedrich A. Hayek, 'Fatal Conceit']

-Congress is nearly dysfunctional, primarily controlled by large corporations, and hamstrung by the supermajority now routinely required in the Senate.

[This is proof that this isn't about the failure of free markets but of corporatism, or crony capitalism. To quote Ron Paul, ``We don't have socialism here, but a mild form of fascism—corporatism--with corporations on the dole, making money off the military-industrial complex, while the banks and financial houses are making money off the monetary system." Again this is nothing new.]

-Government administrations can be incompetent for long periods.

[activist government administrations are almost always incompetent or affected by political goals (public choice economics) or a result of hubris, as Professor Arnold Kling recently wrote, "Libertarianism would indeed say that it takes a genius to do nothing"]

-Poor leadership can really damage a country’s hardwon reputation in a mere 10 years.

[see above]

-Obama is not a miracle worker!

[Again from F. A. Hayek, ``The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." ]

-The leadership of major corporations can be very lacking in insight and competence on a fairly routine basis.

[When governments engage in inflationism, they distort and affect economic calculation of the entrepreneurs, hence the leadership resorts to "lobbying" for political privileges instead]

-The two time-tested investment tools, value (P/E ratios and P/B ratios) and price momentum, are now much more heavily used and not so reliable as they once were, say from 1977 to 1997.

[A validation of Fritz Machlup ``A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply." see our Are Stock Market Prices Driven By Earnings or Inflation?]

-Asset classes really are more inefficiently priced than individual stocks on average, and therefore offer greater opportunities for adding value and reducing risk.

[inflationism distorts pricing, as noted above]

-Developed countries, including the U.S., are past their prime compared with developing countries: it is indeed a new world order.

[too much Keynesianism eventually strips economic advantage of developed countries by diluting wealth through boom bust cycles]

-Education and training are the keys to increasing wealth on a sustainable basis and the U.S. is in danger of losing its once large edge here.

-We all live on an island, which can be overexploited and turned into a barren Easter Island if we are not careful. Resources are finite and biodiversity is fragile, and both must be protected. Carbon emissions are the single greatest threat.

[False! Environmentalism has been a key channel for promoting socialism. The global warming bubble is presently imploding. Besides commodity prices have been on a downtrend for centuries even amidst growing population until today, where inflationism has caused serious dislocations such that these have become underinvested. Moroever, government regulations have caused price surges or overexploitation. Example, oil reserves are 90% owned by state or state owned companies this restricts supply. Further subsidized energy prices leads to greater demand.]

-Being a global policeman is expensive, and somewhere between difficult and impossible.

[Inflationism promotes imperialism that benefits the military-industrial complex.

Again from Ron Paul, ``The pressures exerted on our leadership from the military industrial complex and big business is not in favor of peace or freedom, or especially nonintervention. Intervention is big business. Defense contracts topped $300 billion last year, and total spending on war and our overseas empire is up to $1 trillion per year. That represents a lot of people earning a living off of war and conquest. But rather than adding to our economy, all of this money is taken from the economy in order to wage war and destruction. Imagine if those resources were put to creative, productive use here at home!"]

-The Fed learns no lessons!

[Then Abolish the Fed!]

Overall, it doesn't really take a decade to learn of such harsh lessons, since they have long been studied and transcribed by the Austrian School of Economics into various books or documents.

Kentucky Derby And The Global Stock Markets

``In the stock market, as with horse racing, money makes the mare go. Monetary conditions exert an enormous influence on stock prices. Indeed the monetary climate - primarily the trend in interest rates and Federal Reserve policy - is the dominant factor.” - Martin Zweig

I used to bet on horse races. That’s why I can relate some horse racing activities to the markets.

The spectacular ‘come-from-behind’ victory by a 50 to 1 longshot, Mine That Bird, ridden by jockey Calvin Borel, in the 1^st leg of the US Triple Crown, the Kentucky Derby, held at Churchill Downs at Louisville Kentucky, greatly fascinated me.

Riding into the last quarter length of the 1 ¼ mile leg, Mine That Bird was nearly at the tail end of the 20 horse pack. Jockey Borel then deftly worked his prized horse towards the middle of the pack going into the top of the stretch, elegantly sneaked into the rail for an unobstructed view and unleashed the animal’s full might towards the finish line to rack up an astounding 6-3/4 length win- a wallop! You can watch it online here.

The wonderful partnership of Jockey Borel and Mine That Bird was significantly unexpected in both the betting world (50 to 1 odds) and even in the race track itself-a pulsating come from behind triumph. And today’s electrifying actions in the marketplace seems to match the same rendition-largely unanticipated by mainstream experts and the consensus and equally the unforeseen in speed and magnitude of market movement.

So if I were a horse race bettor I would have reaped enormous dividends had I made a serendipitous bet on that highly underappreciated underdog.

Applied to the markets, it would seem like another major vindication for us, since we had been expecting this from the start of the year. Not only had we projected a general market improvement but we clearly identified a possible outcome an Asian outperformance! (see 2009: Asian Markets Could OUTPERFORM, Will “Divergences” Be A Theme for 2009?,) See figure 1.

Figure 1: US Global Investors: Asia-Latin American Outperformance

The US Global Investors have basically echoed what we have been saying all along (emphasis added), ``So far this year, emerging markets in Asia and Latin America, as represented in blue in the chart, have generally outperformed those in the Middle East/Africa, and Eastern Europe, in yellow and green respectively. Russia and Israel are exceptions. The market has rewarded better balance sheet fundamentals and smaller external and domestic leverage in Asia and Latin America.”

The Philippine benchmark, the Phisix, surged 6.58% over the week to pad its year to date gains by 19.71%. Despite the strong showing, the Phisix’s gain has been transcended by the outstanding run in Singapore (16.56%!!!), Hong Kong (12.04%!!), Taiwan (9.87%!) or even our ASEAN neighbors Thailand (7.33%) and Indonesia (7.69%).

Of course, we are nearly halfway through the year, which means we are still far away from the homestretch, where fluid real time developments may alter present actions, either by further reinforcing our view or going against it.

But almost every indicator has now turned towards a possible fulfillment of our yearend expectations, including my last technical yardstick: the 200-day moving averages, which have become evident in a majority of Asian markets [see Asian Markets: Crossing the Bull Market Rubicon?]!

Moreover, 2010 is the Philippine Presidential election year which has been cyclically strong over the years [as discussed in Focusing On The Future: the Phisix and the Philippine Presidential Cycle].

So general market improvement PLUS next year’s Presidential honeymoon argues for more upside for the Phisix going towards the post elections in 2011.

Of course, like every trend, there will always be intermittent bumps. But what would matter would be the general or the primary trend.

Nonetheless, if the Phisix does end the year above 2,500, we may expect a full recovery (Phisix 3,800) by the end of 2010 or even an attempt at the 5,000.

Horse Racing In the Domestic Market, Noises Over Signals

And even the domestic horse racing mentality has left the starting gates! See figure 2

Figure 2: PSE’s Bull Market Breadth The Advance Decline Ratio, Traded Issues

Where your favorite sell side and mainstream analysts will constantly bombard you with the drivel that stocks are driven by “fundamentals e.g. earnings”, we have argued based on Edwin Lefèvre’s premise from his classic “Reminiscences of a Stock Operator”, ``In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing.”

Mr. Lefèvre, who in behalf of the legendary trader Mr. Jesse L. Livermore, wrote from an empirical standpoint of how markets generally operated.

Nevertheless, we found that his underlying observations have been backed by theory from Mr. Fritz Machlup of the Austrian School of Economics that inflationary policies has had greater impact to stock prices as discussed in Are Stock Market Prices Driven By Earnings or Inflation? and in Phisix: The Case For A Bull Run. This is most pronounced in the Philippine Stock Exchange whose market has been “underdeveloped”.

Notice that the bullish breadth in the Phisix has now been established as seen from the substantial improvement in the advance decline spread (more incidence of positive spread-see left pane), which means today’s market has seen more advancing issues against declining issues. This week, advancers outnumbered decliners by nearly 2.5 to 1.

To add, the number of traded issues (right pane) has conspicuously picked up (red arrow). This translates to the marked broadening of gains in listed issues in the Philippine Stock Exchange.

In other words, as we predicted, even the second and third tier issues have joined the roster of advances. Incidentally, the top 10 gainers over the past sessions appears have been dominated by “speculative” stocks rather than blue chips or Phisix component issues.

In the rapidly shaping “rising tide lifts all boats” environment, which includes “shell” companies, does this landscape then extrapolate to an abrupt shift in earnings expectations to simultaneously turn positive?? The obvious answer is NO. The answer why this phenomenon has been happening is mainly about the percolation of the inflationary driven speculative spirits.

This simply reveals how the world operates.

While truth is a rational subject of interest by anyone or by everyone, it’s always about truth in the way people opt to see or expect them to be, no matter how skewed their version of truth is. As Jeffrey Tucker on a blog article A Tribute to Jack Kemp wonderfully expressed, ``In this world, no matter how firm your credentials, no matter how much capital you have built up over the years, no matter how much press you have received in the past, once you start saying things outside the mainstream, or the mainstream shifts below your feet, you are suddenly a nonperson”.

Being a nonperson is not the issue here. Aside, I am also NOT saying that I have grasped the monopoly of mundane truths. But from the market’s perspective, where there has been little evidence of correlation-causation from so called micro-fundamental driven markets (especially evident in the Philippine setting), the conventional mindset have been apparently molded by mainstream practitioner’s fanatic devotion to peddling noises based on false premises as seen on their literatures, which have only increased the public’s risk profiles.

And poor understanding of markets consequently prompts for wrong impressions and lackluster participation from the general public.

For us, what is crucial is for everyone to comprehend on the evolving market cycles in order to weigh on the risks prospects from which determines our survivability and profit opportunities.

And this requires us to operate under the understanding of the fundamental truisms of winnowing noises from signals, than one based on charades.

Are Stock Market Prices Driven By Earnings or Inflation?

``All political thinking for years past has been vitiated in the same way. People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome. Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind.” -George Orwell, 1984

Theory, Experience and the Consensus Thinking

My first venture into this field gave me the impression that stock market prices had been fundamentally driven by company earnings. Thus I worked my way into the learning the ways to “project” earnings. Now years after, I’ve come to the conclusion that the importance of earnings is secondary.

Yet, such mindset continues to reflect on the consensus thinking. As most of the books, the preaching of the academe and especially the orientations of my peers that are regularly communicated either verbally or through transcriptions via newsletters persist to influence the investing public.

Nonetheless, during the early days, from a strict “fundamental” standpoint, experience altered my perception of the markets. Going along with my contemporaries, I was made to believe that profits involved NOT only earnings, but from special activities as “deals or mergers”. So the goal now shifted from studying corporate fundamentals to one of ascertaining advance information from insiders, and correspondingly took bets on them.

And obtaining insider information meant networking with many people, which prompted me to join forums and groups. Unfortunately, the hunt for financial glory, which turned out to be a profit tryst was nothing but systematic punt and which ultimately taught me an expensive and emotionally agonizing lesson when the market reversed.

Nevertheless during the heydays of the 90s and the subsequent depression, I came to realize too that there had been some blatant inconsistencies with what is understood by consensus based on the dogma of “earnings-as-drivers” and from those acquired through experience.

I realized that on good times everyone seemed energized as the stock market levitated, and on the contrary, during bad times, everyone was either somber or looking for a new endeavor outside the stock market.

Market Tides And Stock Prices

It was then from the classic book “Reminiscences of A Stock Operator” of Edwin Lefèvre or a.k.a the legendary Jessie Livermore that my empirical observations was reinforced.

Remember this Edwin Lefèvre quote which we used to warn of the transitioning bear market in 2007,

``I NEVER hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to think. It is too much bother to have to count the money that he picks up from the ground.”

In contrast to mainstream brokers who ceaselessly bombard you with the hackneyed “earnings-as-drivers” of the market, market reality shows otherwise (see figure 1)

Figure 1: Market Tides Applies to the Phisix Sectors and the World

The upper window is the performance of the sectoral or industrial indices of the Philippine Stock Exchange which spans from 1996 to the present. Do you notice of any material divergence? The answer is none. (chart index: green-Mining, blue-Properties, black-Bank, pink-Commercial Industrial, red-Holding, red orange-service)

The point is stock prices in general, as rightly observed by Mr. Lefèvre, sink or swim depending on market tides.

Do you not wonder why speculative issues or even shell companies greatly outrun cash flow backed fundamental issues during bullmarkets? Or has there been any domestic stock issue (speculative or blue chips) that has been spared from today’s grizzly bear market?

Case Study: Robinsons Land Corporation

Let us make an actual comparison. I will use Robinsons Land Corporation (RLC) as an example. My choice of RLC came about out of availability, it is the company that last reported a disclosure on January 23 (I don’t own RLC) and is likewise Phisix component.

According to the company’s disclosure, “audited consolidated net income by the end of the fiscal year 2008 (October 2007 to Sept 2008) amounted to Php 3.15 billion, up 29% from the same period last year.” Even in 2007, the same figures showed a 42% growth.

On the other hand, its stock prices have COLLAPSED EVEN AS REVENUES CONTINUE TO CLIMB, albeit at a slower DOUBLE DIGIT pace. RLC prices peaked on February 2007 at Php 23 and closed at Php 4.8 Friday or a loss of an astounding 79%!

Yet if stock prices function as forward discounting mechanism based on future earnings streams then the recent stock price trend of RLC conveys a message of a very steep collapse of revenues and earnings, possibly similar to those in the US. Remember, RLC’s stock price slump has been two years old (in 2007 +1.5%, in 2008 -70%)! Usually markets are ahead of fundamentals by 6 months.

And at the close of November of 2008, which is not far from where RLC last traded Friday, according to the PSE, RLC has a dividend yield of 9.14%, 154 basis points higher than the Philippine government 10 year bond (!!!), a price-to-earnings of 5.82, a price to book of .73 and a debt equity of .78.

So the point is, if the market is CORRECTLY pricing future earnings then the company’s balance sheet and income will deteriorate tremendously over 2009 almost 24 months into the RLC price summit. On the other hand, the market may NOT have been reflective of the fair market value of the company and has been INFLUENCED BY OTHER FACTORS HARDLY CORRELATED with the company’s fundamentals.

And if we apply the same logic, the Philippine benchmark the Phisix or the PSEi which has lost nearly 55% from peak-to-trough, has a dividend yield is 5.63%, a PE ratio of 9.76, Price to Book at 1.28 and debt equity of 2.78. Yet the collapsing stock market doesn’t square with the economic figures which registered moderate but POSITIVE growth and NOT a recession.

In short, evidence defies consensus thinking. (I have seen the same story in 2002)

Bubble Cycles Defines Today’s Risks Environment

And curiously we see the same developments overseas. Going back to the chart, from 1999, seen from the lower window, exhibits some of major global benchmarks-S&P 500 (black), Brazil’s Bovespa (blue), Japan’s Nikkei (violet), Hong Kong’s Hang Seng (red) and the Phisix (green)-have ALL moved synchronically.

You might object, but what about my old mining and oil issues that became wall papers? Doesn’t this signify the need for fundamentals?

Well the answer to that question is shown in figure 2.

Figure 2: Cyclical nature of Commodity prices over 200 years

Let us put this into perspective.

This isn’t simply a matter of “speculative” issues that had gone kaput. The fact that Enron, once the 7^th largest company in the US, went bankrupt in 2001, today’s quasi nationalization of the world’s former 18^th largest public company in American International Group (AIG), the bankruptcy of Lehman Brothers, founded in 1850 (!) and was the fourth largest US investment bank, the forced merger of Bear Stearns-also founded in 1923 and was one of the largest US investment banks- with JP Morgan and importantly, the DEMISE of the US investment banking industry (Economist) or the transformation of its relics to bank holdings, only goes to show that whether it is a defunct speculative mining issue in the 1980s or erstwhile blue chip behemoths as today, they are subject to the risk influences of bubble cycles.

And an unwinding bubble cycle,

1. strips the CHIMERICAL INVINCIBILITY of industry leaders (e.g. US investment banks, real estate industry, mortgage lenders and etc…),

2. unmasks FRAUDS and corporate SKULLDUGGERY (e.g. Madoff and Enron) and

3. bankrupt UNVIABLE companies (old speculative mining issue)…

…all of which had been founded or built upon unsound business models.

The Philosopher’s Stone

Bubble cycles are shaped by monetary policies which are aimed at inciting PERMANENT boom conditions by omniscient ‘Powers That Be’, particularly interest rate manipulation.

Yet defying basic economic laws, when interest rates are forced below market levels or at the rate at which the demand for and supply of capital are equalized, excess credit, which the central bank creates, unduly expands demand for assets. Worst of all, by discouraging or even punishing savings, it encourages expanded risk appetite or speculation.

In other words, business projects that shouldn’t have existed at all are given false signals from which they rush in to take advantage of.

Yet, the ensuing illusionary boom distorts the capital structure and overvalues the currency through the intertemporal misallocation of resources or malinvestments, thereby increasing unpredictability into entrepreneurs’ plans. Moreover, an overvalued currency induces a shift of manufacturers overseas.

Hence, the onrush of demand for assets lowers the demand for money which leads to increases in interest rates and which ultimately impacts the feasibility of these unsound business model based companies.

Hence, the boom eventually turns into a bust, where according to Ludwig von Mises, ``The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”

Nonetheless some invaluable insights from the late University of Vienna Professor Fritz Machlup (1902-1983) in The Stock Market, Credit and Capital Formation, on the tight relationship between inflation, bubble cycles and the stock market (bold emphasis mine):

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Extensive and lasting stock speculation by the general public thrives only on abundant credit.

-Abundant funds, especially those of inflationary origin, may not find ready outlets in real investment.

-Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.

-An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

-The use of credit for financing working capital does not assure "self-liquidation" or liquidation free of disturbance. For the economy as a whole circulating capital mostly constitutes long-term investment and, if the volume of production is to be maintained, even permanent investment.

-The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn.

-If bank reserves are controlled by the monetary authorities, credit inflation should not be attributed to the stock-exchange boom. However, margin regulations may be an effective means of checking the expansion.

Conclusion and Recommendations

Overall, here are our observations and recommendations:

1. Seen from the overseas perspective, the transmission mechanism of inflationary policies from the US abetted by global policies geared towards financial globalization or the facilitation of cross border capital flows have narrowed national idiosyncrasies (decoupling) and reinforced synchronization of movements among major global stock market benchmarks (integration) during the recent boom cycle.

The same reverse effects from the credit bubble deflation can be seen today unfolding around the world today. And this convergent stock market deflation theme even applies to most of the US markets (see figure 3) or even to Warren Buffett’s flagship Berkshire Hathaway’s portfolio.

Harry Markowitz, the economist who popularized the Modern Portfolio Theory appears to have been invalidated with the recurring inflation deflation cycle. Today’s market conditions reveal that “diversification” under inflationary policies hasn’t been applicable…yet.

Figure 3: Gavekal: Deflating Margin Debt=Deflating Stock Market

2. Edwin Lefèvre’s empirical observation that individual stock prices move in the general direction of the markets is greatly supported by the role of central bank policies.

3. Monetary authorities have been aware of the significance of this stock market-inflationary policy relationship; hence have partly crafted policies in support of such outlook. As evidence, US Federal Reserve Chairman Ben Bernanke wrote in his A Crash Course for Central Bankers, ``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.”

4. Inflationary/deflationary environments shape risk taking appetites. Under loose monetary conditions or boom cycles, augmented risk appetites translate to a stretching for yields. This also means that the selection breadth by market participants of the asset horizon widens.

In general, like tea poured into a teacup that is filled to the brim, the tea spills over to the saucer and eventually out to the table and to the floor. An easy money landscape extrapolates to a “rising tide lifts all boat” as excess money diffuses to the general market.

And conversely, when the liquidity tide goes out or in bust cycles, you will learn that many have been caught swimming naked (estimated $30 trillion in 2008), to paraphrase the world’s best stock market investor Warren Buffett.

5. Because the Philippine stock market is largely underdeveloped, have low penetration level of exposure, have low degree of sophistication and whose domestic participants have inadequate understanding of the markets and thinks that they are some form of “gambling casinos”, an inflationary environment extrapolates to surging speculative activities which often directs punts to high volatile “issues”.

6. In advanced and sophisticated markets as the US, the weightings of “earnings as driver” may have bigger contribution to pricing relative to underdeveloped markets but as the Berkshire Hathaway portfolio shows has been impacted by the inflation deflation cycle.

7. Unlike typical brokers who will frame and impress on the public with the “earnings as drivers” theme, our advice is to understand not so much of “micro” fundamentals and “market timing”, but more from the unorthodox standpoint of comprehending the market, economic, political-inflationary and business cycles. Markets ultimately as seen today are driven by inflationary actions in the era of fractional standard based modern central banking.

8. Most brokers spread the wisdom of “earnings-as-drivers” theme but tacitly intend to induce trades, where earnings do not seem to matter. They will ask you to open a position based on fundamentals (e.g. PE ratio) and close the same position based on price actions (e.g. sell on resistance). Remember, “fundamentals” and “technical price actions” are distinct tools in approaching the market. Avoid the confusion by identifying, planning and implementing these tools (one or the other or a mix of) before going into any trade/investment.

9. Lastly Professor Fritz Machlup drives a very important point about the prospects of recovery, he says ``The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn”.

Again against consensus thinking, SAVINGS AND NOT CREDIT is likely answer for the recovery.