Self-Discipline and Understanding Market Drivers as Key to Risk Management

Here is an investment tip for those who wish to protect themselves from market volatilities [dedicated to my friends at Stock Market Pilipinas]

As I have been writing, inflationary bullmarkets tend to inflate almost every issue on the stock exchange (rotational process).

This does not apply only to stocks but also to other assets.

In the US, small caps have been beating large caps… (US Global Investors)

…while junk bonds have been thrashing investment grade bonds as US companies with junk ratings pile into the bond markets at record pace to take advantage of ultra low interest rates (Wall Street Journal)

These are evidences of yield chasing phenomenon as an offshoot to central bank policies.

Because the world has been flushed with money, this only implies of highly volatile markets which are characterized by huge swings or strong surges and equally sharp retracements.

Again inflationary markets will tend to push up almost every issue but in different degrees and at different times. This impacts the stock markets in a similar manner. Eventually we will see this happen in consumer prices.

The same phenomenon impacts the second or third tier issues in the local markets, as money spillovers into the broader market.

Second while there will always be unscrupulous people (or stock market manipulators or operators), pump and dump and short and distort are activities that are difficult to establish.

Take for example of the 6 major holding issues constituting the Holding firm index of the Philippine Stock Exchange, 4 have been drifting in near or at record levels.

DM Consunji [PSE: DMC, RED], JG Summit [PSE: JGS, black], and Aboitiz Equity Ventures [PSE: AEV, black] (I did not include Ayala Corp [PSE: AC] because AC has yet to beat, but is about to, the 2007 high)

Are the record levels of stock prices of heavy caps JGS, AEV and DMC (and partly AC) justifying their valuations? So does this make JGS, AEV and DMC a pump and dump?

Some would say no because they are heavyweights (highly liquid issues with real cash flows). But this is would be a non-sequitor or irrelevant to the issue.

The following are the income statement statistics and estimates from 4-traders.com

JGS Summit

Aboitiz Equity Ventures

DMCI

The crux of the matter is: does the earnings trend justify the current price volatility?

In my view no, earnings in the contemporary sense DO NOT justify such volatility as shown above. There seems hardly any correlation between corporate performance and stock prices

And again this brings to fore the largely mistaken orthodox belief about earnings.

Today it has hardly earnings that drive prices but high powered money from central banks. By such thesis, one would understand the nature of inflationary booms and deflationary busts (Was there any pump and dump during the bear market in 2007-2008?)

Nevertheless here are very important tips for stock market participants to keep in mind which I will convey through the wisdom of my favorite stock market savants

Warren Buffett: Risk comes from not knowing what you are doing.

Warren Buffett: The dumbest reason in the world to buy a stock is because it's going up

My comment: Both of the above quotes from Mr. Buffett are intertwined.

Apparently many participants, both neophytes and veterans, are drawn to the fervent desire to earn fast buck while at the same time disregarding the risks involved that makes them easily fall prey to market volatilities and to manipulators.

Jesse Livermore (my all time favorite): “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. He does not wish to work. He doesn't even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

My comment:

Many people don't really want to think.

Example: getting information from newspapers and extrapolating them into investment isn't thinking at all. 50k-100k people read business section of the newspapers everyday. This means by the time one reads the newspaper, others may have already read them and may have already acted on the new information provided.

Yet in reality, these newspaper based information are likely to affect markets over the short run and are splashed with logical errors and fallacies.

That’s why I call the allure of mainstream media’s information as largely toxic.

So instead of working to get ahead of the curve, one acts at the tailend. As a famous Wall Street axiom goes,

Bulls make money, bear make money but pigs get slaughtered.

The desire to improve one’s grasp of the markets requires further scrutiny and goes beyond the conventional analytical methodology.

Moreover, many want to use the stock market to talk themselves or bloat their egos.

Aside from the economic role, stock markets or financial markets have social aspects, which is evident by the bandwagon effects.

More quotes of wisdom

Jesse Livermore: I began to realize that the big money must necessarily be in the big swing. Whatever might seem to give a big swing its initial impulse, the fact is that its continuance is not the result of manipulation by pools or artifice by financiers, but depends on underlying conditions. And no matter who opposes it, the swing must inevitably run as far and as fast and as long as the impelling forces determine.”

Jesse Livermore: In actual practice a man has to guard against many things, and most of all against himself—that is, against human nature.

The basic lesson from the above is that in order to protect one self, one needs to practice self-discipline which means controlling emotions or egos (Emotional Intelligence), as well as, to understand the underlying conditions of the marketplace.

As I previously noted, relying on tips and rumors can be a disastrous proposition.

Manipulators are hardly responsible for losses incurred by market participants. In reality, it is the self who is mostly culpable. Worst, it is policies of political authorities that influences people’s incentives to become short term oriented and to undertake reckless activities and makes them vulnerable to bubbles and to manipulation.

Placebo Effects of Earnings Drives Stock Prices

Here is an excerpt to my note to a special client

Corporate "Fundamentals" serve as placebo to most of the momentum chasers. People look for psychological refuge mostly on what is popular rather than what really works.

A sample of my previous argument in this link.

It is very important to understand that since half of every transactions made by everyone in the marketplace have been based on money or credit—money financed by a financial intermediary that will be paid for with future money or income of the debtor—then policies that tampers with money and interest rates (price of time) affects practically ALL economic and financial activities.

But the impact will not be the same for everyone. Inflationist policies eventually work through a spillover or a trickle down effect.

The first beneficiaries are the wards of the state, the state itself, and the industries or sectors connected to or targeted by the state.

Those affiliated to the first beneficiaries represents as the secondary layer of the inflation multiplier and so on. This is the Cantillon Effect on Money as earlier discussed here

This also extrapolates that people’s incentives, through value scales and time preferences channels, will change in response to these policies. Again the changes will differ from individual to individual.

For instance, today’s negative real rates regime have been prompting many banks to call on me (weekly) to offer credit, which is evidently an offshoot to the current policies which encourages banks to profit from the yield curve through maturity transformation (loans or spread arbitrages) activities.

Those who don’t understand the nature of business cycles may be tempted to add leverage which may induce them to engage in extravagant spending.

If many respond to such policies by taking up loads of debt, then the growth in credit may become systemic in that it reaches levels that may not be adequately financed by aggregate debtor’s income, (perhaps to be pricked by higher interest rates) then the balance sheets of creditor institutions have reached bubble conditions that is bound to burst.

Yet in order to delay the day of reckoning requires sustained credit growth which will likely be facilitated through central banking policies. And this is why central banks exists--to provide backstop to the banking system and to provide finance to the state.

In effect, a financial system that thrives on bubble policies will require sustained credit injections. So many of the company’s business models may transition towards a Hyman Minsky’s Ponzi finance paradigm that only worsens or exacerbate the unsustainable bubble conditions. Remember major US investment banks vanished in 2008.

And there is the social signaling effect. Policies that promote consumption fosters the Keeping up with the Jones’ mentality that tries to lift one’s relative social standings through accumulation of positional material goods. These behavioral changes are partly conditioned, but mainly fueled by monetary policies, promotes what is known as 'consumerism'.

Thus, the subsequent effect of inflationist policies has been to reconfigure social and economic activities through people's incentives.

Consumption, savings and investment patterns, or the effective allocations of resources, has substantially been altered as compared to the non-existence of such policies. The policy induced distortion of the economic coordination process eventually leads to malinvestments and to an eventual discoordination.

Therefore sales, earnings, operating costs, investments, or leverage (gearing) or what in finance nomenclature known as ‘corporate fundamentals’ will be substantially affected, but again on varying degrees.

Of course every markets have individual characteristics too. They are shaped by idiosyncratic culture, unique legal framework, distinct political institutions, individual tax and regulatory regimes, varying depth of the market economy and many many many other variables.

This also means that the earnings principle is NOT a one-size-fits all dynamic. The earnings of the corporations in the US can’t be seen in the same lens as the from earnings of the companies listed on the Philippine Stock Exchange, where many of the latter’s companies have been shielded from competitions or are de facto political concessions. It is important to note that the business environment in the Philippines has been vastly more unfriendly and significantly less competitive than the US, principally due to politically related factors.

The bottom line is that the mainstream’s mathematical or financial construct of earnings DOES NOT accurately describe how policies shape or affect them. That said, earnings hardly will function as a reliable metric for the ascertainment of stock values.

So like the Heisenberg uncertainty principle, the entrenched orthodox belief in earnings is like trying to pin down an elusive target that never really is, or signifies as vain attempts to get hold of the Holy Grail--especially when markets have been vastly distorted or artificially boosted by rampant interventionism and inflationism. This is based more on faith or groupthink than of functionality.

Effects must not be read as the cause.

Earnings Drive Stock Prices? International Container Terminal and Ayala Land

I picked the following charts because of the availability of charts that depict on their profit growth trends

The following is the 6 year chart of International Container Terminal [PSE: ICT]

During the three major cycles since 2006, ICT skyrocketed 410%, crashed by 78% (from peak to trough) and in the current uptrend soared by a whopping 474% from the bottom in the 1^st Quarter 2009.

Here is ICT’s profitability chart from 4-traders.com

While the growth rate for ICT’s profits did fall in conjunction with the decline in ICT share prices in 2007-2009, one should realize that profits were still strongly POSITIVE. In short, there has been no justification for the 70% decline under the premises of earnings-as-driver of stock prices.

Yet there are two notable discrepancies during the last 2 bull cycles of ICT. Profit growth had been modest in 2005-2007. Today, the same growth rate has seen a decline even as share prices continues to etch new record highs. In short, share prices have little correlation with actual earnings performance.

The next chart is Ayala Land Inc, [PSE: ALI] contemporary market leader of the Phisix since the start of the year

We see the same pattern in ALI. ALI surged 130% in the 2006 to the peak of 2007, plummeted 74% during the last bear market and is at an eye-popping 327% from the troughs of 2009.

Same story with ICT. Growth rate of profits does not justify ALI’s extreme price volatility in both directions during the last three cycles. The company exhibits steady, incremental and low volatility in earnings growth which is typical of blue chips.

Here is what I see.

-There has been a loose correlation between earnings and price values

-Considerable price volatilities do not match with the pace of earnings growth.

-Philippine stocks sink and swim in tides as discussed here and here

Looking at earnings as the main driver of prices seems like watching the Heisenberg uncertainty principle in quantum mechanics at work—“it is impossible to pin down the position and momentum of a subatomic particle beyond a certain degree of accuracy; the very attempt to determine the position of an electron (by firing light at it) will itself change its momentum” (Robert Murphy, Human Action Study Guide).

In short, using earnings as key parameter for investing in the Philippine market seems like a nebulous target, you’d never know if or when this is going to work for you, except that this serves as an excuse to piggyback on the current bullrun.

Above is the PE ratio of the Phisix according to the IMF.

Considering the huge jump in prices from the start of the year, we should be around at near the peak of 2007. So anyone who believes in this stuff ought to be shorting or selling the market. I won’t.

As a caveat, like individuals, national stock markets bear their own respective idiosyncrasies so they shouldn't be seen or valued in a one-size-fits-all dimension.

Also one should realize that as central banks around the world, including the Philippines, intervene in the financial monetary system, there will be material impacts to profitability, operating costs and leverages and other corporate matters. In short, business decisions or economic calculations will also be distorted.

Nevertheless, earnings for me, like charts, function as a secondary and or a confirmatory signal rather than the prime mover.

New Record Highs for the Philippine Phisix; How to Deal with Tips

I worry less about small failures, more about large, potentially terminal ones. I worry far more about the "promising" stock market, particularly the "safe" blue chip stocks, than I do about speculative ventures-the former present invisible risks, the latter offer no surprises since you know how volatile they are and can limit your downside by investing smaller amount. I worry less about advertised and sensational risks, more about the more vicious hidden ones I worry less about terrorism than about diabetes, less about matters people usually worry about because they are obvious worries, and more about matters that lie outside our consciousness and common discourse (I also have to confess that I do not worry a lot - I try to worry about matters I can do something about) I worry less about embarrassment than about missing an opportunity. Nassim Nicholas Taleb The Black Swan The Impact of the Highly Improbable

Rampaging stock market bulls has propelled the local benchmark, the Phisix to another milestone record high!

Friday’s electrifying breakout anchored by a 2.4% advance, largely influenced by developments overseas, essentially pushed the Phsix farther away from the 13 month consolidation level (green channel). This seems to reinforce the new support level, which formerly was represented by the resistance level (upper green horizontal line).

Of course, price charts merely function as guides, as they are ultimately driven, not by patterns, but by the value-scale time preference exhibited by the marketplace or by market participants acting through the price mechanism.

The Global Boom Phase

It is important to keep in perspective what has been driving actions in the stock markets.

Where the mainstream associates today’s milestone feat to ‘economic growth’, ‘earnings growth’, ‘confidence’ to the political affairs or to some other bunk, it is worth accentuating that what has been happening in the Philippines has not been an insulated event but a global phenomenon.

The exemplary performance by the local bellwether has not even kept pace with the remarkable advances by many of the world’s bourses.

While the Phisix has assumed on the leader’s role relative to the performance of our nieghbors or the ASEAN-4, we even trail the returns of another ASEAN member particularly Vietnam’s 14.72% on a year-to-date basis.

The exceptional gains by Hong Kong and India as indicated in the above table as one of the top performers in the world, has also outclassed the Phisix.

Yet most of Asia has been up by over 10%, except for China, Indonesia, Malaysia, Australia and New Zealand. Only Sri Lanka, Bangladesh and Mongolia registered losses over the same period.

And of the 71 international bourses on my radar screen, 42% have posted gains of over 10%. Such broad based bullishness has simply been astounding.

Intensifying Local Boom

In the local markets, again, the bullmarket sentiment has not been limited to select issues, particularly to heavyweight components of the Phisix, but to the broader market.

While we should be expecting a natural profit taking process or a countertrend to occur anytime, overbought conditions in a bullmarket may remain extended.

Such dynamics may be taking place.

The recent decline in the advance-decline differentials (averaged weekly) seems to have augured for a retracement. However, Friday’s intense rally may have deferred anew what should have been a normal profit taking sequence.

The market’s sentiment can be measured by the trading activities or internal market actions.

The average daily traded issues, which has been ascendant since November of 2011, has also been exhibiting signs of exhaustion. Friday’s rally has not alleviated the weekly decline.

So far market breadth seems indicative of a coming salutary profit taking cycle.

This week’s rally has evidently been led by the service sector via gains of the major telecom issues. The property and the financial indices, took second and third spot, have similarly bolstered the gains of the Phisix.

On a year-to-date basis the property and the financial sector continues to widen their lead relative to their contemporaries, whose gains have mostly been responsible for the outstanding returns of the Phisix.

And if we are to look at the biggest companies within the Phisix basket, whose ranking are based on free float market cap, the actions of the heavyweight basically confirms the standings of the sectoral performances.

Property issues led by Ayala Land [ALI] have taken the commanding lead, along with SM Primeholdings [SMPH] at fourth spot.

Meanwhile, the financial sector has been powered by BPI and MBT at third and fifth spot respectively. Ayala Corp, the mother unit to ALI and BPI, at second place has also been buoyed by the gains of the sizzling hot subsidiaries.

And in evaluation of the above dynamics there are several things to keep in mind:

One, the gains of the Phisix hasn’t been limited to Phisix based heavyweight components but manifested on the overall markets. This means that market’s attention has been percolating into second or third tier issues.

Two, the rotational process has been in progress, where past laggards are today’s darling and yesterday’s favorites have become the du jour laggards. Such dynamics are being exhibited in the actions of the Phisix heavyweights, which have been confirming the sectoral rankings. The interchanging gains with the Mining industry[1] relative to the other capital intensive sectors of the property and telecoms, along with financial sector, which functions as the financial intermediaries of these industries, signify as symptoms of a mounting inflationary boom. In short, the real relative effects of monetary inflation[2] are being likewise being demonstrated in the actions in the stock markets, here and around the world.

Also the rotational process extrapolates to the shifting market’s attention from heavyweights to second or third tier issues and vice versa which can also be a dynamic found within specific sectors.

The bottom line is that for as long as the monetary inflationary push persists, the Phisix will continue to ascend, but the distribution of gains will vary in terms of degree and of timing seen from sector to sector and from heavyweights to tiered issues.

Inflationary Credit Fueling the Boom Phase

There is another very important aspect to remember in the environment where everybody is a genius.

To quote the legendary trader Jesse Livermore via Edwin Lefèvre in the must read classic Reminiscences of a Stock Operator[3], (emphasis added)

The public ought always to keep in mind the elementals of stock trading. When a stock is going up no elaborate explanation is needed as to why it is going up. It takes continuous buying to make a stock keep on going up. As long as it does so, with only small and natural reactions from time to time, it is a pretty safe proposition to trail along with it.

Sustained broad stock market gains will not occur if funded by savings alone. Since savings are limited or are scarce, market will then reflect on offsetting actions—i.e. gainers would be counterbalanced by losers, where net gains will only emerge from dividends. It is under such environment where earnings would truly matter.

Austrian economist Fritz Machlup provides the economic underpinnings to Mr. Livermore’s empirical observation[4] (emphasis added)

A factor which is capable of evoking expectations of a rise in security prices is a reduction of the interest rate. In so far as this reduction occurs merely as the result of an increased supply of intended new savings, the likelihood of a long-lasting upward movement of the market is rather meagre.

In addition, since stock markets operate on the principle of pricing, then any increase in the demand for stocks through higher prices would likewise entice more supply (more listings). This would again entail offsetting actions under a savings only financed milieu

Again from Mr. Machlup continuing from the same paragraph,

It is easy to see that if dividend prospects are unchanged increased and the rate of interest is reduced, security prices will rise, and it is more than probable that a sufficient amount of security sales from "final sellers' (unloading by temporary holders and new issues) will be quickly forthcoming: comparatively small offerings of securities will suffice to absorb the increased supply of new savings and to drain them off to other markets. For no matter how the supply of money capital derived from current new savings may fluctuate, it is scarcely conceivable that the total supply of money capital can ever rise to unexpected dimensions as the result of an increased flow from this source. If the public devotes only its new savings to the securities market, and the new demand at once causes some groups of securities to become "firmer," it will not be necessary for the purchasing power of the public to be withdrawn from the commodity market until it has "run through'* all the securities quoted on the exchange and has adjusted the prices of securities, one after the other, to the new market conditions.

In the present world, boom conditions spread from the markets to the real economy.

Yet the boom phase of the business cycle, as reflected in the actions of the stock markets requires continuous infusion of credit to facilitate an increase in demand for stocks.

Mr. Machlup further explained[5],

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 amortization 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.

And such a boom can only happen when interest rates have been tampered with to produce a negative real rate environment.

Today’s boom can easily be traced to seemingly coordinated policies by global central banks to allegedly fight economic downturn with an environment of negative real rates.

Zero interest rate policies (ZIRP) have become the conventional creed utilized by central bankers as shield against the publicized menace of recessions. In reality, these measures have been designed to buttress and preserve the beleaguered banking system from a collapse.

Interest rates today on a global scale have been approaching the 2009 levels[6], although policy rates directives of emerging markets have been less aggressive compared to crisis afflicted developed economies[7].

This week, we see the same patterns of credit easing policies in some of the major economies. Sweden cut interest rates[8], China pared down the banking sector’s reserve requirements for the second time in 3 months[9] and importantly, the Bank of Japan (BoJ) surprised the markets by aggressively expanding quantitative easing (QE) which according to them is slated to be completed by the end of 2012[10].

While the markets were palpably surprised by BoJ’s announcement, to the contrary we had expected this, as I wrote last week[11]

…politicians have been pressuring the Bank of Japan (BoJ) to ease further or face a revision of the BoJ law in order to “give the government more room to intervene in monetary policy”. This is an example of the sham in the so-called central banking independence.

Central banks are politically influenced directly or indirectly. The BoJ will be stepping on the QE gas pedal. Yet, if Japan’s government manages to remold on the BoJ law which gives Japanese politicians the space to intervene directly, then the yen will be faced with greater risk of hyperinflation.

This serves a reminder that central banks are politically influenced and that any talks of the completion of QE should be taken with a grain of salt. Political agents change their statements almost as fast as they change their underwear.

So credit easing measures will continue, with pretext of economic doom as cover for their actions.

And yet the actions of central bankers have been percolating into to the real economy, through the commodity sphere. Oil has broken out of the consolidation- quasi cup and handle formation while Natural gas which has been on a decline, largely influenced by the Shale gas revolution has suddenly surged. If the uptick in natural gas prices continues in spite of the expansion of the Shale gas output, then we could be seeing seminal signs of what Ludwig von Mises calls as the “crack up” boom or the intensifying symptoms of monetary disorder.

Jesse Livermore’s Investing Tip: Don’t Listen to Tips!

In a bullmarket, everyone’s a genius. That’s because ascendant prices will varnish many mistakes used in the evaluation stock price trends. Tersely put, many will be right for the wrong reasons. And the natural ramifications from easy money made from a bull run will be overconfidence, embedding of wrong analytical methodology (where many analyses are really just heuristics) and greater risk appetite.

Since broad market gains are the character of the typical bullmarkets, issues which are commonly deemed as ‘speculative’ or ‘third’ tier or in local colloquial terminology known as ‘basura’ issues will be imbued with magnificent gains symptoms of which we are seeing today.

The common conventional attribution for spectacularly performing speculative issues are that they are being spurred by undisclosed or yet to be disclosed insider activities which have been channeled as rumors, gossips or insider tips.

In reality while there may be some truth to such insider based plans and developments, the causal linkage between price actions and insider activities have not been straight forward. Such rumor based price action relationship hardly exists during bear markets.

Insider tips usually signify as available bias or looking at current events or scouring for any “available” seemingly plausible information to explain the market’s actions or the post hoc fallacy.

And insider tips are ultimately dependent on general market sentiment.

In short, negative real rates or the increase in people’s time preference have impelled market participants to look for all sorts of justifications to buy into the markets.

Another important factor is that insider tips can be subject to the machinations of stock market operators.

Again from the profound wisdom of the celebrated trader Mr. Jesse Livermore via Mr. Lefèvre[12] (bold emphasis added)

Tips! How people want tips! They crave not only to get them but to give them. There is greed involved, and vanity. It is very amusing, at times, to watch really intelligent people fish for them. And the tip-giver need not hesitate about the quality, for the tipseeker is not really after good tips, but after any tip. If it makes good, fine! If it doesn't, better luck with the next. I am thinking of the average customer of the average commission house. There is a type of promoter or manipulator that believes in tips first, last and all the time. A good flow of tips is considered by him as a sort of sublimated publicity work, the best merchandising dope in the world, for, since tip-seekers and tiptakers are invariably tip-passers, tip-broadcasting becomes a sort of endless-chain advertising. The tipster-promoter labours under the delusion that no human being breathes who can resist a tip if properly delivered. He studies the art of handing them out artistically

And relying on tips to goad for a buying action equally requires dependence on tips on how to close the transaction. More from Mr. Livermore[13].

A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don't believe in tips. If I buy stocks on Smith's tip I must sell those same stocks on Smith's tip. I am depending on him.

Also relying on tips would seem like depending on the advice of quack doctors on your health. Yet again Mr. Livermore[14],

I have said many times and cannot say it too often that the experience of years as a stock operator has convinced me that no man can consistently and continuously beat the stock market though he may make money in individual stocks on certain occasions. No matter how experienced a trader is the possibility of his making losing plays is always present because speculation cannot be made 100 per cent safe. Wall Street professionals know that acting on "inside" tips will break a man more quickly than famine, pestilence, crop failures, political readjustments or what might be called normal accidents.

These seem like common sense and easy to observe advise that has been hardly practised by most participants. And the reason for this is due to our intuitive attachment to emotions which embodies our human frailty[15].

There are many thousands of people who buy and sell stocks speculatively but the number of those who speculate profitably is small. As the public always is "in" the market to some extent, it follows that there are losses by the public all the time. The speculator's deadly enemies are: Ignorance, greed, fear and hope. All the statute books in the world and all the rules of all the Exchanges on earth cannot eliminate these from the human animal. Accidents which knock carefully conceived plans skyhigh also are beyond regulation by bodies of coldblooded economists or warm-hearted philanthropists. There remains another source of loss and that is, deliberate misinformation as distinguished from straight tips. And because it is apt to come to a stock trader variously disguised and camouflaged, it is the more insidious and dangerous

Despite enrolling in the school of hard knocks, many fail to heed on such fundamental lessons.

Finally, for investment success, the proof of the proverbial pudding is in the eating. Mr. Livermore’s priceless counsel[16],

Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks. Then get out of all your stocks; get out for keeps! Wait until you see or if you prefer, until you think you see the turn of the market; the beginning of a reversal of general conditions. You have to use your brains and your vision to do this; otherwise my advice would be as idiotic as to tell you to buy cheap and sell dear. One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

Mr. Livermore’s line of thinking emanates from an empirical or pragmatic point of view which unknowingly to him, his ideas have been backed by sound economic theory.

Mr. Livermore’s emphasis on gains comes in form of capturing magnitude and not on the frequency. And this is the opportunity that buy-and-hold in a conditional bull market or the boom phase of the bubble cycle offers.

Prudent investing means to manage one’s portfolio under such direction.

---

[1] See Graphic of the PSE’s Sectoral Performance: Mining Sector and the Rotational Process, July 10, 2011

[2] See Phisix and the Rotational Dynamics, January 30, 2012

[3] Lefèvre, Edwin Reminiscences of a Stock Operator p.255 os24.org

[4] Machlup Fritz The Stock Market, Credit And Capital Formation, p.90 Mises.org

[5] Machlup, op. cit. p.92

[6] See Global Central Banks Ease the Most Since 2009, November 28, 2011

[7] Centralbanknews.info Emerging Markets Monetary Policy Rate Indicator, February 18, 2012

[8] Bloomberg.com, Sweden Abandons Rate Rises as Euro Crisis Hits Nordics: Economy February 16, 2012

[9] Bloomberg.com China Cuts Bank Reserve Reqs; Exports ’Grim’, February 19,2012

[10] Danske Research Nerves on edge, but brighter outlook Weekly Focus, February 17, 2012

[11] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2012

[12] Lefèvre op.cit. p.166

[13] Lefèvre op.cit. p.27

[14] Lefèvre op.cit. p.256

[15] Lefèvre op.cit p.245

[16] Lefèvre op.cit p.55

Phisix and the Rotational Dynamics

It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. [I]f the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with 'free banking.' The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.- Former US Federal Reserve chairman Paul Volcker

The Phisix fell 1.43% for the first time in four weeks. This comes after a turbocharged advance since the start of the year. Year to date, the local benchmark has been up 7.04% based on nominal Peso returns. But for foreign investors invested in the Phisix, the returns are higher. Since the Philippine Peso has materially gained (over 2%) from the same period, returns from local equity investments in US dollar terms is about 9+%.

Could this week’s decline presage a correction phase?

Rotational Dynamics in the PSE and the Cantillon Effects

The decline of the Phisix has not been reflected over the broad market as exhibited by the positive differentials of the advance-decline spread. This means more issues gained despite the natural corrective profit taking process seen on many of the Phisix component heavyweights.

And leading the market gainers has been the mining index which seems to have reasserted the leadership after a rather slow start. Also defying the profit taking mode has been the industrial sector.

From the start of the year, despite this week’s retrenchment, the property sector remains the best performer followed by the mining and the financial sectors.

This week’s market activities demonstrate what I have always called as the rotational process or dynamic. Sectors that has lagged outperforms the previously hot sectors which currently has been on a profit taking mode. Eventually the overall effect is to raise the price levels of nearly issue.

Here is what I previously wrote[1],

A prominent symptom of inflation is that prices are affected unevenly or relatively.

Eventually prices in general moves higher, but the degree and timing of price actions are not the same.

It’s the same in stock markets, which represents as one of the major absorbers of policy induced inflation.

Prices of some issues tend go up more and earlier than the others. At certain levels, the public’s attention tend to shift to the other issues which has lagged. This brings about a general rise in prices.

These are the spillover effects which I call the rotational process.

The mining sector has been narrowing the gap with the property sector and has surpassed service and financial sectors. The industrial sector which has been the tail end, has shrugged off the current profit taking process.

In the real economy, the effects of inflation has been similar, this known as the Cantillon Effect (named after the Mercantilist era Irish French economist Richard Cantillon) who brought about the concept of relative inflation or the disproportionate rise in prices among different goods in an economy[2]

The great Murray Rothbard dealt with the social and ethical considerations of Cantillon Effect or the relative effects of inflationism to an economy[3]

The new money works its way, step by step, throughout the economic system. As the new money spreads, it bids prices up--as we have seen, new money can only dilute the effectiveness of each dollar. But this dilution takes time and is therefore uneven; in the meantime, some people gain and other people lose. In short, the counterfeiters and their local retailers have found their incomes increased before any rise in the prices of the things they buy. But, on the other hand, people in remote areas of the economy, who have not yet received the new money, find their buying prices rising before their incomes. Retailers at the other end of the country, for example, will suffer losses. The first receivers of the new money gain most, and at the expense of the latest receivers.

Inflation, then, confers no general social benefit; instead, it redistributes the wealth in favor of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race--to see who can get the new money earliest. The latecomers--the ones stuck with the loss--are often called the "fixed income groups." Ministers, teachers, people on salaries, lag notoriously behind other groups in acquiring the new money. Particular sufferers will be those depending on fixed money contracts--contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."

The distributional impact of an inflation generated boom means the chief beneficiaries of inflation policies are the first recipients of new money who constitutes the political agents (politicians, bureaucrats), the politically privileged (welfare beneficiaries) or politically connected economic agents (war contractors, government suppliers, cronies and etc.). Where they spend their newly acquired money on will then serve as entry points to the diffusion of these new (inflation) monies to the economy.

The impact of current series of inflation policies works the same way too, they are meant to benefit, not the economy, but the insolvent banking and financial system of developed nations and their debt dependent welfare states teetering on the brink of collapse. And such policies have partly been engineered to buoy the financial markets (stock markets, bond markets and derivatives markets) because the balance sheets of their distressed banking system have been stuffed or loaded with an assorted mixture of these paper claims.

In the stock market, a similar pattern occurs, early receivers of circulation credit who invest on stock markets will benefit at the expense of the latecomers, usually the retail participants, where at the end of every boom, retail investors are left holding the proverbial empty bag.

As Austrian economist Fritz Machlup wrote,

the money which flows onto the stock exchange and is tied up in a series of operations, need not come directly from stock exchange credits (brokers' loans) but that any "inflationary” credit, no matter in what form it was created, may find its way onto the stock exchange[4]…

Extensive and lasting stock speculation by the general public thrives only on abundant credit[5].

So for as long as the interest rate environment can accommodate an expansion of inflationary or circulation credit, then stock markets are poised for an upside move.

Rotational Dynamics Abroad

The distributional and rotational dynamic can also be seen in the actions of ASEAN-4 bourses where Thailand’s SET has swiftly been closing on the lead of the Phisix on a year to date basis, while Indonesia and Malaysia has yet to get started.

Not only have the rotational effects been manifested in the region but also seem to be percolating around world.

Of the 71 bourses in my radar list, only about 18% have been in the red. The current environment has been the opposite of what we have seen in 2011.

And importantly, similar to the dynamics dynamics in the Philippine Stock Exchange, last year’s laggards have currently been outperforming.

About two weeks ago, the Philippine Phisix took the second spot[6] after Argentina among world’s top performing bourses. Apparently the relative effects of inflation has prompted for a strong recovery for the previous tailenders—such as the BRICs [Brazil, India, and Russia to the exclusion of China whose bourses have been closed for the week in celebration of the Year of Dragon] and developed economies as Germany and Hong Kong as well as a fusion of other nations from developed as Austria to the frontier markets Peru—to eclipse the gains of the Phisix and Argentina.

Central Banking Fueled Inflationary Boom

Financial markets have only been responding to what seems as synchronized efforts to deluge the world with liquidity in the hope that these efforts would lead to a structural economic recovery.

Unfortunately such short term oriented policies will only mask the problems by delaying the required adjustments and at worst, build or compound upon the current imbalances which would significantly increase systemic fragility which ultimately leads to a bubble bust.

Four central banks cut interest rates this week[7] (Thailand, Israel, Angola and Albania) with India paring down on the reserve requirements—mandated minimum reserves held by commercial banks.

Most of the world’s major central banks have been enforcing an environment of negative real rates, where as I have earlier noted, global interest rates reached the lowest level since 2009[8].

Meanwhile the US Federal Reserve recently announced the extension of the incumbent zero interest policy (ZIRP) rates “at least through late 2014”[9] on economic growth and unemployment concerns.

Also US Federal Reserve Chair Ben Bernanke has again been signaling the prospects of the revival of Fed’s bond buying which he said is “an option that is certainly on the table”[10].

In reality, the Bernanke led US Federal Reserve has been using the economy as cover or as pretext to rationalize the funding of what has been the uncontrollable spending whims by US politicians, aside from providing support to the banking system (both the US and indirectly Europe), which serves as medium for government to access financing.

However it would seem that access to financing windows has been closing.

The US debt ceiling, without fanfare, had been raised anew[11], which accounts for the relentless increase in the spending appetite of the incumbent administration.

Next foreign financing of US debts are likely to shrink, perhaps not because of geopolitical issues but because economic developments could alter the current financing dynamics. For instance, Japan’s trade balance posted a deficit for the first time in 31 years[12] and that China’s trade surpluses have been steadily narrowing[13]. China has already been reducing its holding of US treasuries.

If the trade balance of the key traditional financers of the US turns into extended deficits, this would put a cap on funds from Japan and China. Unless other emerging markets will fill in their shoes, and with low domestic savings rate, the US government will be left with the US Federal Reserve as financier of last resort. Of course, the Fed may possibly work in cahoots with other central banks through the banking system to accomplish this.

This only translates to a growing dependency on the printing press for an increasingly debt reliant welfare-warfare based political economic system.

And importantly, monetization of debts would have to be supported by zero bound rates to keep the US treasury’s interest expenditures in check.

So the current debt and debt financing dynamics will imply for a deeper role of the US Federal Reserve. All of which will have implications to markets and the production aspects.

Yet Bernanke’s nuclear option (helicopter drop approach) has palpably become the conventional central bank policy doctrine for global central bankers, specifically for most of developed economies.

There is no better way to show of the unprecedented direction in central bank policymaking than from the aggregate expansion of, in terms of US dollar, the balance sheets of 8 nations (US, UK, ECB, Japan, Germany, France, China and Switzerland) in order to keep the current system afloat.

By such nonpareil actions, there would no meaningful comparisons in modern history (definitely not Japan circa 90s or the Great Depression)

Deflation as Political Agenda and the Fallacy of Money Neutrality

It is important to stress that the mainstream’s obsession with so-called deleveraging process, although part of this is true, operates in an analytical vacuum. For their analysis forgoes the political incentives of the central banks to forestall the markets from clearing. For allowing the markets to clear will translate to a collapse in the current redistribution based political system. Deflation, a market clearing process, is a natural consequence to the distortions brought upon by prior inflationary policies or the boom bust cycle.

The irony is that those who benefit from inflation (government and banks), will be the ones who will suffer from deflation.

As Professor Jörg Guido Hülsmann explains[14],

the true crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners. This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers. Both deflation and inflation are, from the point of view we have so far espoused, zero-sum games. But inflation is a secret rip-off and thus the perfect vehicle for the exploitation of a population through its (false) elites, whereas deflation means open redistribution through bankruptcy according to the law.

Thus the shrill cry over deflation amounts to nothing more than a front for vested interest groups who insists on pushing forward the inflationism agenda. Yet despite years of ceaseless incantations about deflation, asset markets and economic activities have behaved far far far away from the scenarios deflationists have long been fretting about. To contrary the risks has been tilted towards higher rates of consumer inflation.

I would further add that another mental lapse afflicting mainstream analysts, who embrace the “we inhabit a deflation, deleveraging reality”[15] mentality is that their aggregatism based economic analysis sugar-coats what in reality signifies as largely heuristics or mental short cuts predicated on political beliefs or appeal to acquire readership or catering to the mainstream to get social acceptance.

They believe that money printing by central banks has neutral effects—which means changes in money supply would lead to a proportional and permanent increase in prices that has little bearing on real economic activity as signified by output, investment and employment.

In reality, prices are determined by subjective valuations of those conducting exchanges, given the particular money at hand, the goods or services being traded for and the specific timeframe from which trade is being consummated, thus changes in the supply of money will not affect prices proportionally.

Money is never neutral. Professor Thorsten Polleit explains[16],

What is more, money is a good like any other. It is subject to the law of diminishing marginal utility. This, in turn, implies that an increase in the stock of money will necessarily be accompanied by a drop in money's exchange value vis-à-vis other goods and services.

Against this backdrop it becomes obvious that a rise or fall of the money supply does not confer a social benefit: it merely lowers or raises the exchange value of the money unit. And a change in the money supply also implies redistributive effects; that is, a change in money stock is not, and can never be, neutral.

So even as central banks continue with their onslaught of adding bank reserves at a pace that has never happened in modern history, they believe that such actions will be engulfed by “deleveraging”.

And going back to the “policy trap” or path dependency of policymaking that has been tilted towards inflationism, as said above, the balance sheets of crisis affected financial and banking institutions greatly depends on artificially bloated price levels. And in order to maintain these levels would require continuous commitment to inflationary policies, which means compounding or pyramiding inflation on top of existing inflation. Inflation thus begets inflation.

Again Professor Machlup[17],

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.

And anytime central banks’ desist or even slow the rate of these expansions, this would entail or usher in violent downside volatilities in the marketplace (including the Phisix). Thus “exit strategies” signify no less than political agitprops.

A noteworthy and relevant quote from James Bianco[18], (which includes the chart above)

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets. As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.

When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light. Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling. The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.

So how does one know that “expanding balance sheets will no longer be looked upon in a positive light” considering that central banks can elude accounting rules? My reply would be to watch the interest rate price actions, currency movements and prices of precious metals along with oil and natural gas.

No Decoupling, a Redux

Any belief that the Phisix operates separately from the world would be utterly misguided.

2011 should be a noteworthy example.

The Phisix ended the year marginally up while the US S&P 500 was unchanged. Except for the first quarter where the S&P 500 and the Phisix diverged (green oval, where ironically the US moved higher as the Phisix retrenched), the rest of the year exhibits what seems as synchronized actions. Or that based on trend undulations, the motion of the Phisix appears to have been highly correlated with that of the S&P.

While correlation does not translate to causation, what has made the US and the Phisix surprisingly resilent relative to the world has been the loose money policies adapted by the US Federal Reserve. Money supply growth in the US has sharply accelerated during the latter half of the year despite the technical conclusion of QE 2.0.

Not only has such central bank actions partly offset and deferred on the potential adverse impact from the unfolding crisis in the Eurozone, aside from exposing internal weaknesses, monetary inflation has buoyed the US financial markets.

The deferment of recession risks magnified the negative real rates environment in the Philippines and the ASEAN financial markets which has prompted for the seemingly symmetrical moves and the outperformance relative to the world.

My point is that the notion where Philippine financial markets will or can decouple or behave independently from that of the US, or will not be affected by developments abroad, has been baseless, unfounded, in denial of reality and constitutes as wishful and reckless thinking that would be suicidal for any portfolio manager.

Final Thoughts and Some Prediction Confirmations

Bottom line:

Given the added empirical indications of an ongiong an inflationary boom, here and abroad, the current correction phase seen in the Phisix will likely represent a temporary event

The seemingly synchronized actions by global central bankers to lower rates allegedly to combat recession risks will magnify the negative real rate environment that should be supportive of the bullish trend in both the Phisix and the Philippine Peso and also for global markets.

The hunt for yield environment will be concatenated by the debasing policies of central banks of major economies which will likely spur international arbitrages or carry trades.

Before I conclude, I would like to show you some confirmations of my predictions

An inevitable confirmation of my assertion that the actions of central bankers represent as the main drivers of price trends and not chart patterns[19] can be seen in the above chart from stockcharts.com.

The price actions of the US S&P 500 segues from the bearish death cross, which now officially represents a failed chart pattern, that gives way to the bullish golden cross.

Above is another vital confirmation of my thesis against gold bears who claimed that December’s fall marked the end of the bull market[20]. Gold has broken out of the resistance level which most possibly heralds a continuation of the momentum that would affirm the bullmarket trend.

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[1] See Phisix: Why I Expect A Rotation Out of The Mining Sector, May 15, 2011

[2] Wikipedia.org Richard Cantillon Monetary theory

[3] Rothbard, Murray N. 2. The Economic Effects of Inflation III. Government Meddling With Money What Has Government Done to Our Money?

[4] Machlup Fritz The Stock Market, Credit And Capital Formation p.94 William Hodge And Company, Limited

[5] Ibid p. 289

[6] See Global Equity Markets: Philippine Phisix Grabs Second Spot, January 14, 2012

[7] centralbanknews.info, Monetary Policy Week in Review - 28 January 2012, Bank of Albania Cuts Interest Rate 25bps to 4.50%

[8] See Global Central Banks Ease the Most Since 2009, November 28, 2011

[9] Bloomberg.com Fed: Benchmark Rate Will Stay Low Until ’14, January 26, 2012

[10] Bloomberg.com Bernanke Makes Case for More Bond Buying, January 26, 2012

[11] See US Senate Approves Debt Ceiling Increase, January 27, 2012

[12] AFP Japan posts first annual trade deficit in 31 years, January 25, 2012, google.com

[13] Bloomberg.com Shrinking China Trade Surplus May Buttress Wen Rebuff of Pressure on Yuan, January 9, 2012

[14] Hülsmann Jörg Guido Deflation And Liberty, p.27

[15] Mauldin John, The Transparency Trap, January 29, 2012 Goldseek.com

[16] Polleit Thorsten The Fallacy of the (Super)Neutrality of Money, October 23, 2009 Mises.org

[17] Machlup Fritz op. cit, p 291

[18] Bianco James, Living In A QE World January 27, 2012 ritholz.com

[19] See How Reliable is the S&P’s ‘Death Cross’ Pattern? August 14, 2011

[20] See Is this the End of the Gold Bull Market? December 15, 2011