Economic Myth Busted: In the US, Savings from Lower Gas Prices was Spent on even More Gas!

Remember the popular mantra/incantation “low oil prices equals more consumer spending”? (this applies not only to the US but elsewhere including Philippines too)

Well, in the US, a study debunks the popular myth: savings from lower gas prices was spent on even more gas!

And bizarrely, media and ‘experts’ blame such unexpected course of development on human irrationality!

From the New York Times  (bold mine)

When gas prices fall, Americans reliably do two things that don’t make much sense.

They spend more of the windfall on gasoline than they would if the money came from somewhere else.

And they don’t just buy more gasoline. They switch from regular gas to high-octane.

A new report by the JPMorgan Chase Institute, looking at the impact of lower gas prices on consumer spending, finds the same pattern as earlier studies. The average American would have saved about $41 a month last winter by buying the same gallons and grades. Instead, Americans took home roughly $22 a month. People, in other words, used almost half of the windfall to buy more and fancier gas.

This is not rational behavior. Americans spent about 4 percent of pretax income on gas in 2014. One might expect them to spend about the same share of any windfall at the pump — maybe a little more because gas got cheaper. Instead they spent almost half.

Americans, in short, have not been behaving like the characters in economics textbooks…

The study, based on the spending patterns of about one million JPMorgan customers, does not track the kind of gas consumers purchased. It shows that people bought more gas as prices fell, and that the increase in consumption is not sufficient to explain the entirety of the increase in spending on gas.

Here is what the law of demand says “all else being equal…as the price of a product decreases, quantity demanded increases.” 

"People bought more gas as prices fell..."

Have consumers not been “behaving like the characters in economics textbooks”? Really? Or have consumers not been behaving in accordance to the fictitious outcomes generated from econometric models?

Of course, such econometric models have been constructed principally on the assumptions that humans DO NOT act based on ever changing preferences and values, in the face of an equally dynamic complex environment, that shapes incentives and consequently their actions. Or in short, for the math pedagogues, humans are NOT humans but automatons or robots whose actions are programmed.

But one may retort, they shifted from “regular gas to high-octane gas”.

So why not? Perhaps high octane gas could have been seen as more "energy efficient" (more fuel savings or longer driving mileage). If so then this reinforces, the law of demand.

But refuting the mythological gas-savings-equal-to-consumption-binge meme goes beyond the statistical technicalities.

Yet as I have noted here and many times elsewhere: the economics of spending is MAINLY a derivative of INCOME conditions—secondarily the utilization of savings and of credit—and NOT from the changes in spending patterns or the redistribution of spending from static income.

And as for the perspective of economic punditry versus real world phenomenon, the great Ludwig von Mises warned (Misapprehended Darwinism, Refutation of Fallacies, Omnipotent Government p.120)

Nothing could be more mistaken than the now fashionable attempt to apply the methods and concepts of the natural sciences to the solution of social problems. In the realm of nature we cannot know anything about final causes, by reference to which events can be explained. But in the field of human actions there is the finality of acting men. Men make choices. They aim at certain ends and they apply means in order to attain the ends sought.

Now whose behavior have not been rational…acting humans or ‘experts’ whose views have been shaped by rigid econometric models?

Ludwig von Mises: The Peculiar and Unique Position of Economics

In celebration of this year's Holy week, residents of the Philippines will be having a long weekend.

So before I sign out for the week, here is a recommended read on the importance of economics and its effects to society and politics as articulated by the great Austrian economist Ludwig von Mises excerpted from Human Action (1949), chapter 37, "The Nondescript Character of Economics."

From the Mises Institute: (bold mine)

The Singularity of Economics

What assigns economics its peculiar and unique position in the orbit both of pure knowledge and of the practical utilization of knowledge is the fact that its particular theorems are not open to any verification or falsification on the ground of experience. Of course, a measure suggested by sound economic reasoning results in producing the effects aimed at, and a measure suggested by faulty economic reasoning fails to produce the ends sought. But such experience is always still historical experience, i.e., the experience of complex phenomena. It can never, as has been pointed out, prove or disprove any particular theorem. The application of spurious economic theorems results in undesired consequences. But these effects never have that undisputable power of conviction which the experimental facts in the field of the natural sciences provide. The ultimate yardstick of an economic theorem's correctness or incorrectness is solely reason unaided by experience.

The ominous import of this state of affairs is that it prevents the naïve mind from recognizing the reality of the things economics deals with. "Real" is, in the eyes of man, all that he cannot alter and to whose existence he must adjust his actions if he wants to attain his ends. The cognizance of reality is a sad experience. It teaches the limits on the satisfaction of one's wishes. Only reluctantly does man resign himself to the insight that there are things, viz., the whole complex of all causal relations between events, which wishful thinking cannot alter. Yet sense experience speaks an easily perceptible language. There is no use arguing about experiments. The reality of experimentally established facts cannot be contested.

But in the field of praxeological knowledge neither success nor failure speaks a distinct language audible to everybody. The experience derived exclusively from complex phenomena does not bar escape into interpretations based on wishful thinking. The naïve man's propensity to ascribe omnipotence to his thoughts, however confused and contradictory, is never manifestly and unambiguously falsified by experience. The economist can never refute the economic cranks and quacks in the way in which the doctor refutes the medicine man and the charlatan. History speaks only to those people who know how to interpret it on the ground of correct theories.

Economics and Public Opinion

The significance of this fundamental epistemological difference becomes clear if we realize that the practical utilization of the teachings of economics presupposes their endorsement by public opinion. In the market economy the realization of technological innovations does not require anything more than the cognizance of their reasonableness by one or a few enlightened spirits. No dullness and clumsiness on the part of the masses can stop the pioneers of improvement. There is no need for them to win the approval of inert people beforehand. They are free to embark upon their projects even if everyone else laughs at them. Later, when the new, better, and cheaper products appear on the market, these scoffers will scramble for them. However dull a man may be, he knows how to tell the difference between a cheaper shoe and a more expensive one, and to appreciate the usefulness of new products.

But it is different in the field of social organization and economic policies. Here the best theories are useless if not supported by public opinion. They cannot work if not accepted by a majority of the people. Whatever the system of government may be, there cannot be any question of ruling a nation lastingly on the ground of doctrines at variance with public opinion. In the end the philosophy of the majority prevails. In the long run there cannot be any such thing as an unpopular system of government. The difference between democracy and despotism does not affect the final outcome. It refers only to the method by which the adjustment of the system of government to the ideology held by public opinion is brought about. Unpopular autocrats can only be dethroned by revolutionary upheavals, while unpopular democratic rulers are peacefully ousted in the next election.

The supremacy of public opinion determines not only the singular role that economics occupies in the complex of thought and knowledge. It determines the whole process of human history. 

The customary discussions concerning the role the individual plays in history miss the point. Everything that is thought, done and accomplished is a performance of individuals. New ideas and innovations are always an achievement of uncommon men. But these great men cannot succeed in adjusting social conditions to their plans if they do not convince public opinion.

The flowering of human society depends on two factors: the intellectual power of outstanding men to conceive sound social and economic theories, and the ability of these or other men to make these ideologies palatable to the majority.

Voluntary Exchange vs. Government Mandates: Why State ownership is not real ownership

At the Mises Institute, Austrian economist Patrick Barron eloquently explains the difference between individual (voluntary) transactions and government interventions or mandates: (italics original; bold mine)

The basic unit of all economic activity is the uncoerced, free exchange of one economic good for another. Moreover, the decision to engage in exchange is based upon the ordinally ranked subjective preferences of each party to the exchange. To achieve maximum satisfaction from the exchange, each party must have full ownership and control of the good that he wishes to exchange and may dispose of his property without interference from a third party, such as government.

The exchange will take place when each party values the good to be received more than the good that he gives up. The expected — but by no means guaranteed — result is a total higher satisfaction for both parties. Any subsequent satisfaction or dissatisfaction with the exchange must accrue completely to the parties involved. The expected higher satisfaction that one or each expects may not be dependent upon harming a third party in the process. 

Third Parties Cannot Create Value by Forcing Exchange 

Several observations can be deduced from the above explanation. It is not possible for a third party to direct this exchange in order to create a more satisfactory outcome. No third party has ownership of the goods to be exchanged; therefore, no third party can hold a legitimate subjective preference upon which to base an evaluation as to the higher satisfaction to be gained. Furthermore, the higher satisfaction of any exchange cannot be quantified in any cardinal way, for each party's subjective preference is ordinal only. 

This rules out all utilitarian measurements of satisfaction upon which interventions may be based. Each exchange is an economic world unto itself. Compiling statistics of the number and dollar amounts of many exchanges is meaningless for other than historical purposes, both because the dollars involved are not representative of the preferences and satisfactions of others not involved in the exchange, and because the volume and dollar amounts of future exchanges are independent of past exchanges. 

One Example: The Case of Ethanol 

Let us examine a recent, typical exchange that violates our definition of a true exchange yet is justified by government interventionists today: subsidized, protected, and mandated use of ethanol.

The use of ethanol is coerced; i.e., the government requires its mixture into gasoline. Government does not own the ethanol, so it cannot possibly hold a valid subjective preference. The parties forced to buy ethanol actually receive some dissatisfaction. Had they desired to purchase ethanol, no mandate would have been required.

Because those engaging in the forced exchange did not desire the ethanol in the first place, including the dollar value of ethanol sales in statistics purporting to measure the societal value of goods exchanged in our economy is meaningless. Yet the government includes all mandated exchanges as a source of “value” in its own calculations.

This is just one egregious example of many such measurements that are included in our GDP statistics purporting to convince us that we have "never had it so good." 

Another Example: The Soviet Economy 

Our flawed view that governments can improve satisfaction caused us to misjudge the military threat of the Soviet Union for decades. Our CIA placed western dollar values on Soviet production data to arrive at the conclusion that its economy was growing faster than that of the US and would surpass US GDP at some point in the not too distant future. Except for very small exceptions, all economic production resources in the Soviet Union were owned by the state. This does not necessarily mean that it was possible for the state to hold valid subjective preferences, for those who occupied important offices in the state held them at the sufferance of what can only be described as gang lords, who themselves held office very tentatively. 

State ownership is not real ownership. Those in positions of power with responsibility over resources hold their offices for a given period of time and have little or no ability to pass their office on to their heirs. Thus, the resources eventually succumb to the law of the tragedy of the commons and are plundered to extinction. Nevertheless the squandering of the Soviet Union's commonly held resources was tallied by our CIA as meeting legitimate demand.

Professor Yuri Maltsev saw first-hand the total destruction of the Soviet economy. In Requiem for Marx he gives a heartbreaking portrayal of the suffering of the Russian populace through state directed, irrational central planning that did not come close to meeting the people's legitimate needs, while our CIA continued to crank out bogus statistics of the supposed strength of the Soviet economy upon which the Reagan administration based its unprecedented peacetime military expansion. 

Peaceful Exchange Allowed, Violent Exchange Redressed

With the proviso that no exchange may harm another, as explained so well in Dr. Thomas Patrick Burke's book No Harm: Ethical Principles for a Free Market, we are led to the conclusion that no outside agency can create greater economic satisfaction than can a free and uncoerced exchange. The statistics that support such interventions are meaningless, because they cannot reflect the satisfaction obtained from true ordinally held subjective preferences. Once this understanding is acknowledged and embraced, the consequences for the improvement of our total satisfaction are tremendous. Our economy can be unshackled from government directed economic exchanges and regulations. 

Even the individual's preferences are fickle or may change across time. So aggregating numbers can provide a misleading picture of actual conditions.

 

This represents a teleological reason to doubt those government ‘aggregate’ numbers.

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

A Creeping Déjà vu of the February 2013 Mania

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

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

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

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

Creepy coincidence no?

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

So far history has rhymed.

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

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

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

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

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

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

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

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

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

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

Fugasi

The Indonesian Stock Market Bubble

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

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

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

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

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

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

Let us hear it from Bloomberg[4]:

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

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

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

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

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

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

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

The gains have been mentioned but not the losses.

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

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

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

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

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

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

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

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

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

And here is where it gets interesting.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Indonesian Property Bubble

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Does Moody’s have a Clue?

Going back to the Philippines.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Does Moody’s have a clue?

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

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

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

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

Does Moody’s have a clue?

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

Does Moody’s have a clue?

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

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

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

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

Does Moody’s have a clue?

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

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

Phisix’s Price Earnings Bubble

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

I have an update that covers the entire Phisix index 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

---

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

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

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

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

[5] 2012 Indonesia ING International Trade Study

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

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

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

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

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

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

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

[13] Indonesia-Investments.com 24 Indonesian Provinces Have Set New Regional Minimum Wage for 2014 November 15, 2013

[14] see Phisix: The Myth and Realities of a Yearend Rally November 6, 2013

[15] Antaranews.com Eurocham urges Indonesian govt to ease business regulations February 22, 2014

[16] see Indonesia’s Boom: Resource Based or Credit Bubble? April 11, 2013

[17] Jakarta Globe Fitch Warns of ‘Bubble-Like Symptoms’ for Indonesia March 13, 2014

[18] Oxford Business group Indonesia’s housing market likely to cool March 13, 2014

[19] Reuters.com Analysis: Indonesia's stock market set for another boost from earnings March 12, 2014

[20] Bloomberg.com Debt Exceeds $100 Trillion as Governments Binge, March 10, 2014

[21] Inquirer.net Moody’s: Sudden stop of inflows won’t hurt PH March 14, 2014

[22] Ludwig von Mises Uncertainty August 4, 2007 Mises.org

[23] See Will San Miguel’s Minsky Moment Occur in 2014? January 13, 2014

[24] See Phisix: The BSP’s Self Imposed Hobson’s Choice, March 9, 2014

[25] IMF Malaysia STAFF REPORT FOR THE 2013 ARTICLE IV CONSULTATION February 14, 2014

[26] See Phisix: Will the Global Risk OFF Environment Intensify? February 3, 2014

[27] See Emerging Market $2 trillion Carry Trade: The Pig in the Python February 24, 2014

[28] Richard Feynman Cargo Cult Science From a Caltech commencement address given in 1974

[29] Ed Easterling The P/E Report: Quarterly Review Of The Price/Earnings Ratio January 6, 2014 Crestmont Research

[30] See Phisix: Stagflation is here, Expect a Weaker Peso February 17, 2014

[31] Wall Street Journal Poverty Is Stubborn Foe in Philippines March 12, 2014

[32] MediaIndia.net Schooling Extended to 13 Years By Philippines May 17, 2013

[33] See How Bro. Armin Luisitro’s 12 Year Basic Education Cycle Will Benefit The Big League Schools, August 10, 2010

Economic Forecasting: The Mainstream’s Horrible Track Record

Aside from the agency problem, here is another reason why economic and market predictions or forecasts by mainstream "experts" should be taken with a grain of salt.

From Wall Street Journal Economics Blog: (bold mine)

Last month, Singapore’s government announced the economy grew 3.8% on-year in the second quarter. But as late as June, economists polled by the city-state’s central bank were predicting growth of just 1.5%.

Economists got it wrong on exports too: They predicted a nearly flat print in the second quarter, when exports actually fell 5.0%.

The difference was even starker in the first quarter: Economists in March predicted exports would fall 0.5%, but in fact they shrank a whopping 12.5%.

The Monetary Authority of Singapore polls economists at banks and research firms every quarter on key local data such as gross domestic product, exports, currency, inflation and employment. The results are released at the start of every quarter, with the third-quarter survey landing Wednesday.

It turns out that the 20 or so economists who respond to the survey get it quite wrong, quite often.

Economic predictions are never easy. But they become even more complex in tiny Singapore, where trade is more than three times the size of GDP.

Why this is so? The great Austrian professor Ludwig von Mises explained (Human Action page 31): (bold mine)

The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged. Historical experience as an experience of complex phenomena does not provide us with facts in the sense in which the natural sciences employ this term to signify isolated events tested in experiments. The information conveyed by historical experience cannot be used as building material for the construction of theories and the prediction of future events. Every historical experience is open to various interpretations, and is in fact interpreted in different ways

Even non-Austrian analyst, statistician and author Nassim Nicolas Taleb calls such error Historical Determinism as I previously pointed out

Reading or interpreting past performance (statistics) into the future along with seeing the world in the lens of mathematical formalism (econometrics) are surefire ways to misinterpret reality.