2008 Global Meltdown: From Financial Markets To The Real Economy

The OECD recently published its global composite leading indicators (CLI) for major OECD nations and non OECD nations.

Below is the graphical depiction of the CLIs signifying the synchronized economic collapse in 2008....(charts from OECD)

Of course, all these economic indicators matches the actions in the financial markets…

Global equities (DJW), the Baltic Index (BDI) a barometer of global shipping rates and commodity prices (CRB) almost simultaneously a swan dive…

As the US dollar managed to surge…

The chronology of the above events from our perspective:

1. Building pressures of a financial collapse eventually found a release valve despite policies thrown to avert these.

2. The ensuing global financial markets meltdown led to a seizure in operations of the global banking sector.

3. The financial paralysis, which summed to shortage of available and accessible US dollars as the liquidation process snowballed, spurred the skyrocketing of the US dollar’s exchange value.

4. Lacking access to credit, Trade finance froze!

5. The banking sector’s inaccessibility and dearth of liquidity compounded crumbling assets led to the abrupt curtailment of orders across producers.

6. Reeling from the aftershocks of the seizure of the global banking sector, the real economy suffered from a spillover.

Will Previous Crisis Serve As Deserving Guidepost For Today’s Crisis?

At a social affair, last night, an acquaintance brought up the issue of how long this crisis could possibly last. [As usual this analyst stammered.]

Fortunately a study by Harvard’s Ken Rogoff and Carmen Reinhart over previous episodes of financial/banking, real estate crisis should give some clue. (Hat tip: John Maudlin)

Although it is best to be reminded that in reading history, things are always obvious after the fact. And that conditions that have led to the crisis may be “deterministic” to quote Nassim Taleb, whose conditions which have led to such may not be always be identified or observed.

So for those groping for an answer, here are some points or bullets from the Rogoff-Reinhart study (all quotes and charts from Rogoff-Reinhart study:

On the real estate bust:

-The cumulative decline in real housing prices from peak to trough averages 35.5 percent.

-The most severe real housing price declines were experienced by Finland, the Philippines, Colombia and Hong Kong. Their crashes were 50 to 60 percent, measured from peak to trough.

-The housing price decline experienced by the United States to date during the current episode (almost 28 percent according to the Case–Shiller index) is already more than twice that registered in the U.S. during the Great Depression

-Notably, the duration of housing price declines is quite long-lived, averaging roughly six years (with Japan 17 years!)

On the Effect to Equities:

-the equity price declines that accompany banking crises are far steeper than are housing price declines, if somewhat shorter lived.

-The average historical decline in equity prices is 55.9 percent, with the downturn phase of the cycle lasting 3.4 years

See below…On Unemployment:

-On average, unemployment rises for almost five years, with an increase in the unemployment rate of about 7 percentage points. While none of the postwar episodes rivals the rise in unemployment of over 20 percentage points experienced by the United States during the Great Depression, the employment consequences of financial crises are nevertheless strikingly large in many cases.

-when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced economies. While there are well-known data issues in comparing unemployment rates across countries, the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress.

-The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.

On GDP:

-The average magnitude of the decline, at 9.3 percent, is stunning.

-post– World War II period, the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit. When foreign capital comes to a “sudden stop,” to use the phrase coined by Guillermo Calvo, Alejandro Izquierdo, and Rudy Loo-Kung (2006), economic activity heads into a tailspin.

-Compared to unemployment, the cycle from peak to trough in GDP is much shorter, only two years.

-the recessions surrounding financial crises have to be considered unusually long compared to normal recessions that typically last less than a year.

On debt buildup

-same buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century. We look at percentage increase in debt, rather than debt-to-GDP, because sometimes steep output drops would complicate interpretation of debt–GDP ratios.

-the characteristic huge buildups in government debt are driven mainly by sharp falloffs in tax revenue and, in many cases, big surges in government spending to fight the recession.

-The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.

Their conclusion:

``An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. Unemployment rises and housing price declines extend out for five and six years, respectively. On the encouraging side, output declines last only two years on average. Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt.

``How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience. On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.

``Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks lain down by historical precedent. The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature. The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end. As Reinhart and Rogoff (2008b) highlight, defaults in emerging market economies tend to rise sharply when many countries are simultaneously experiencing domestic banking crises.”

Our observations:

-present crisis in the US isn’t just about a real estate crisis but a combination of both real estate and banking crisis since the real estate industry depended on Wall Street to fuel its bubble. This risks extending the duration of the economic slump! The previous averaged about 6 years (Rogoff-Reinhart) where today the US housing bust is only 3 years old!

-the US centric crisis hasn’t been just about real estate bubble bust and bank recapitalization issues but also about falling tax revenues and state deficits and importantly household balance sheet impairments. So it is going to be difficult to make precise assessment using past data.

-for the Philippines today, the decline of 56% squares with “the average historical decline in equity prices is 55.9 percent”. But since we did not suffer from a banking crisis but got unduly affected by the chain process of global forcible selling, “the downturn phase of the cycle lasting 3.4 years” has got to be lower.

-Rogoff-Reinhart: “the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit.”

Previous crisis lumped as one was either “regional or individual” as rightly noted by the authors. Today’s crisis is global (also rightly pointed out). But the important difference is where the crisis emanated from.

Although the apparent fallout dynamics identified by the Rogoff-Reinhart study had been present in today’s crisis even when the epicenter had been in the US, it is because present dynamics has yet been exhibiting the privilege of the US dollar as the world' currency reserve.

But this seems to be changing, for the new year, a news report says that China is offering its neighbors to trade directly in their currency,

from BBC, ``China has said it is to allow some trade with its neighbours to be settled with its currency, the yuan. The pilot scheme was announced in a package of measures designed to help exporters hit by the global downturn…Officials did not say when the trial scheme would start. When it does, the yuan could be used to settle trade between parts of eastern China (Guangdong and the Yangtze River delta) and the territories of Hong Kong and Macau, and between south-west China (Guangxi and Yunnan) and the Asean group of countries (Brunei, Burma, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand and Vietnam).”

In short, “abrupt reversals in the availability of foreign credit” could happen on a different context. As the common Wall Street precept says, ``Past performance may not guarantee future outcome."

-Very interesting commentary from Rogoff-Reinhart: ``The gaps in the social safety net in emerging market economies, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.”

Could the welfare “mentality” of developed economies have contributed to the unemployment predicament, compared to “gap filled” or “less safety nets” in emerging markets? Or put differently, has free markets contributed to better employment recovery for EM during the past crisis?

Here we are reminded of Ludwig von Mises in Human Action, ``The policies advocated by the welfare school remove the incentive to saving on the part of private citizens. On the one hand, the measures directed toward a curtailment of big incomes and fortunes seriously reduce or destroy entirely the wealthier peoples power to save. On the other hand, the sums which people with moderate incomes previously contributed to capital accumulation are manipulated in such a way as to channel them into the lines of consumption.”

-Rogoff-Reinhart: “The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.”

We can see now why Mr. Rogoff had been calling for inflating the value of debts away (see Kenneth Rogoff: Inflate Our Debts Away!). He believes that bailout costs would have a “minor” impact on the economy going forward, but his conclusions were premised upon comparisons made during the past crisis when they had been “individual or regional” in nature, whereas today’s crisis is global.

Thus, it is a wonder just how valid his thesis will be.

2008 Trivia: Lobby, Bailouts and Losses

2008 ushered in a season for lobbying, bailouts and record losses…

First, amidst the present financial crisis, the lobbying business is now booming as Washington decides the winners and losers…

This from thehill.com, ``At the top of the economic agenda, however, is an economic stimulus package that could reach $850 billion, ranking among the biggest federal expenditures in history. Democratic leaders are drafting the package now in hopes of passing it before Obama takes the oath of office.

``With so much money on the table, lobbyists are working late into the holiday season to pitch their clients’ needs to the bill’s authors…

``Tony Podesta, a high-profile Democratic lobbyist, said it’s too risky for companies to cut their lobbying budgets when Congress is poised to pass landmark legislation. If anything, he said, it’s time to increase spending.

“Lobbyists and discounters may be the only people who grow,” he said"

Two, the lobbying interests has been expanding to cover almost every industry.

Some projects or programs floated or proposed by state and local officials include (Washington Post):

· $4.8 million for a polar bear exhibit in Rhode Island.

· $100 million to redevelop land for a casino in Philadelphia.

· $13 million in improvements in Las Vegas, much of it for a pedestrian bridge at the Tropicana hotel-casino.

· A yet-to-be-determined amount for a proposed $50 million museum in Las Vegas devoted to organized crime.

· $6 million for snow-making and maintenance facilities at Spirit Mountain, Minn.

So former President of Federal Reserve Bank of St. Louis, William Poole is absolutely right when he said, “Everyone knows that a policy of bailouts will increase their number.”

Next, across the pond, the bailout response has likewise been a contagion; the floundering “native” cheese making industry of Italy is getting rescued too! Italy’s government will be buying nearly 200,000 wheels cheese to be distributed to charity.

Courtesy of the Independent.co.uk

According to the Independent, ``Parmigiano Reggiano, Italy's King of Cheese, is in trouble. Robust in flavour and crumbly, it is a classic of Italy's artisan food traditions, made by hand by 430 craft producers around the city of Parma. But with Italian consumption falling as costs soar, almost a third of producers now face bankruptcy. Now Italy's Minister of Agriculture, Luca Zaia, has come to the rescue, promising to buy 100,000 Parmigiano Reggiano cheeses, and also 100,000 of its less costly competitor, Grana Padano.

``This is Italy's big cheese bailout. Essentially, the government will be gobbling up 3 per cent of Parmesan production at an estimated cost of €50m (£44.7m) and distributing it to the needy. Each 35kg wheel of Parmigiano costs between €8 and €8.50 to make, but the wholesale price has declined for the past four years even as the cost of milk and energy has soared.”

Of course, not everyone will be pleased since others belonging to the same industry won’t be as privileged. From the Telegraph, ``Producers of Italy's other celebrated cheese - buffalo mozzarella - are looking on enviously after suffering an 18 per cent drop in sales in the last year. "We've asked for help too," said Vincenzo Oliviero, the head of Italy's mozzarella producers association, which has yet to receive an injection of state aid."

See what we mean by government deciding the winners and losers?

Going back to the US, the government spending binge has also been creating some sets of new problems in terms of project efficacies, transparency and accountability.

This from Yahoo.news, ``Government officials overseeing a $700 billion bailout have acknowledged difficulties tracking the money and assessing the program's effectiveness.

``More broadly, the officials discussed "the difficulty of isolating the effects" of the bailout program "given the variety of policy actions taken by the U.S. government to support financial stability and promote economic growth."

``The officials also noted the "difficulties associated with monitoring the use of specific funds" provided to individual financial institutions, according to the document…

``The government has pledged to provide $250 billion to banks in return for partial ownership. The goal is for banks to use the money to boost lending. However, a recent review by The Associated Press found that after receiving billions in aid from U.S. taxpayers, the nation's largest banks can't say exactly how they're spending the money. Some wouldn't even talk about it.

``The idea behind the capital injection program is for banks to use the money to rebuild reserves and lend more freely to customers. However, banks do have leeway to use the money for other things, such as buying other banks, paying dividends to investors or bonuses to executives. That's touched a nerve with some lawmakers and other critics."

Talk about first few signs of unintended consequences.

The year won’t be complete without the tabulation of government money earmarked for rescue and stimulus programs and of estimates for market and economic losses from the financial crisis.

Some excerpts from the tally sheet of Bloomberg’s Alexis Leondis,

``$30: Approximate amount, in trillions, erased from the value of stocks worldwide.

Bloomberg: World Market Cap index

``$8.6: Amount, in trillions, of taxpayer money the U.S. government has pledged to prop up cash-strapped financial companies as of Nov. 25, according to data compiled by Bloomberg.

``$61,871: Maximum amount the bailout could cost each taxpayer, based on 139 million tax returns filed last year.

``$882: Amount, in billions, of U.S. currency in circulation, according to Bloomberg data.

``$613: Amount, in billions, listed as liabilities when Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in U.S. history.

``$150: Amount, in billions, of taxpayer money pledged to help American International Group Inc.

```11.7: Number, in millions, of households that owe more on their mortgages than their homes are worth, according to Zillow.com

Read the rest here.

From New York Times

Additional losses from hedge funds and stock mutual funds, as noted by Bloomberg, ``It has been a year of record misery: the largest bankruptcy, bank failure and Ponzi scheme in U.S. history; $720 billion in writedowns and losses by financial institutions; $30.1 trillion in market valuation wiped out.

``Hedge funds lost 18 percent of their value for the year through November, the worst year since record-keeping began in 1990, according to Chicago-based Hedge Fund Research Inc. Morgan Stanley estimated that, by year end, at least 620 hedge funds will have closed.

``At bottom, the debacle amounted to a loss of faith, especially for individual investors. They pulled $215.7 billion from stock mutual funds in the first 11 months of the year, according to Investment Company Institute, a Washington-based association. That compares with a $91 billion inflow of funds for the same period of 2007.

``As a result of those withdrawals and market losses, the total net assets in all types of mutual funds fell by $2.67 trillion in the first 11 months of 2008, the institute reported.”

Yet to complete the year’s amazing finish, Forbes presents a list of Billionaires shedding some of their networth with isolated accounts of billionaires going to a net worth of ZERO. (no intentional schadenfreude here but to depict that today's crisis hurt even those at the highest strata)

From Forbes “Billionaire Blow ups”,

``More than 300 of the 1,125 billionaires we tallied on our annual list last March have since lost at least $1 billion; several dozen lost more than $5 billion. The 10 richest from our 2008 rankings dropped some $150 billion of wealth, dragged down by steel tycoon Lakshmi Mittal, estranged brothers Mukesh and Anil Ambani and property baron K.P. Singh, who together dropped $100 billion. America's 25 biggest billionaire losers of 2008 lost a combined $167 billion.”

Click here for

In Pictures “Billionaire Blow Ups”

In Pictures “America's 25 biggest billionaire losers”

The Rise of Value Investors Amidst A Prevailing Fear and Loss Environment

``If stocks are attractive and you don't buy, you don't just look like an idiot, you are an idiot.'' -Jeremy Grantham, Baron Buys, Grantham Spots `Once in Lifetime' Chance

It is a curiosity to occasionally hear questions about profitability in today’s market similar to “Are you up or down?”

Because for as long as people have positions in the financial market whether directly (equities, fixed income, currencies, commodities) or indirectly (mutual funds, hedge funds, ETF, UITF and etc.) the unequivocal answer is that given today’s downside volatility-losses are the rule, not the exception.

Today’s Fad: Losses Everywhere

Think of it; nearly $30 trillion of market capitalization wiped out from global equity markets year to date alone. Banks have written off about $680 billion and still counting. As we earlier argued in Spreading the Wealth? Market IS Doing It!, the political morality polemics about income inequality has been in a wash since market losses appear to have sizably narrowed the controversial gap.

Still world real estate market continues to bleed; in the US estimates of losses have been at $1 trillion (globeandmail.com). We don’t have the collateral damage estimates or casualty figures from the fallout in other markets, most especially in Europe and in some other parts of Asia, which includes China or Japan or Australia.

Nevertheless, we have also enormous unaccounted for losses in the derivative, currency (a roster of emerging market victims from Reuters), commodities, bonds, structured finance and other financial markets.

Retirement accounts of baby boomers have been nursing some $2 trillion in the deficits (msnbc.com), thereby putting in jeopardy the retirement plans of many Americans. With Americans likely to work longer, apparently the incoming Obama presidency would have to deal with policies related to health insurance costs, Social security and Private Pensions and flexible work arrangements to address the challenges of the coming transition.

Moreover, the losses have now been spilling over to the real economy enough to impact corporate bottom lines and dividends. In the US, according to the Howard Silverblatt of S&P (Businessweek), earnings growth which had originally been optimistically forecasted at 14.2% for the third quarter have so far posted 13.9% in the red with 77% of companies reporting.

And by corporations we also mean major pension funds and retirement institutions.

As an example many Filipinos are familiar with the US largest retirement fund, The California Public Employees Retirement System, known as CalPERS, which accounted for a total portfolio value of $185 billion on Friday, down 23% from $239 billion at the start of its fiscal year. (latimes.com). The CalPERS fund is down by nearly $54 billion.

According to the same article, ``CalPERS "is taking hits across all asset classes," Feckner said. But the losses would have been even greater "if we had not spread our money out" by diversifying investments….For now, working with interim executives, CalPERS is sticking with a strategy that leans heavily on stocks, which account for about 40% of its holdings. No decision has been made about shifting the investment mix -- possibly toward bonds and other fixed-income assets, Feckner said.” (emphasis mine)

The point is; much like the CalPERs experience, investing in markets is NOT about “trying to time the markets”, as to literally assess one’s portfolio as being “up or down”, but applying portfolio management across the company’s risk profile and time horizon objectives.

In addition, President Rob Feckner underscores the viciousness of the present bear market as impacting “across all assets” meaning that the collateral damage has been broad based and severe enough for most investor’s to escape its wrath.

Warren Buffett Has Been NOT Immune

Figure 1: stockcharts.com: year-to-date performance of Mr. Buffett’s Berkshire Hathaway

Because of ferocity of the bear markets, not even gurus are immune.

We have spilled so much ink about the wondrous feat of the world’s most successful investor Warren Buffett, but viewed from real world developments, Mr. Buffett’s investments have not been entirely unaffected see Figure 1.

On a year-to-date basis, Berkshire Hathaway has fallen victim to the powerful grip of bearmarket forces with its share prices down over 20%. And it is not just in share prices, but likewise reflective of corporate bottom line performance, with most of the damage emanating from derivatives related losses.

Some important highlights from CNN Money, ``Warren Buffett's Berkshire Hathaway Inc. on Friday reported a 77% drop in third-quarter earnings, hurt by declining insurance profits and a $1.05 billion investment loss…

``Berkshire began the year with an unrealized $1.67 billion loss on its futures, options and other derivative contracts. The value of those derivatives, which are tied to the value of the overall markets and the credit health of certain companies, improved in the second quarter by $654 million. But in the third quarter amid unprecedented market turmoil, their value fell by $1.05 billion, leaving a loss of $2.21 billion through the first nine months of the year…

``Berkshire finished the third quarter with $33.4 billion cash on hand. That is up from the end of the second quarter when the company had $31.2 billion cash on hand…

``Year to date, Berkshire's net worth slipped to $120.15 billion from $120.73 billion, but during October, price declines in investments and increased liability for equity index put option contracts accounted for a $9 billion decline in net worth.”

So similar to CalPERs, the troubles of Warren Buffett’s flagship in Berkshire Hathaway have been mainly due to the downside repricing of its asset holdings than from the direct impact of the economic downturn to its operations (yes, insurance and Berkshire’s Mid American subsidiary Constellation Energy has suffered from losses).

Remember, Berkshire Hathaway isn’t just your typical fund manager, but is an active investor to manifold diversified industries tacked into the company’s portfolio as subsidiaries, unlike CalPERs which functions principally as passive investors.

A second observation is that as we wrote in Warren Buffett Declares A BUY!, the recent months have shown Berkshire increasing its cash portfolio but over the year have plunked some $11 billion into the markets. Its cash holdings is still a significant 30% relative to the company’s overall net worth, but down from 40% at the start of the year when using the present net worth figures as basis.

Nonetheless, investments in the market doesn’t have to come directly from Berkshire as some of its subsidiaries have been doing the dirt work of expanding via acquisitions such as office furniture CORT which recently acquired Aaron Rents Corporate furnishing for $72 million (bizjournals).

So yes, while Mr. Buffett’s long term holdings are temporarily “down”, influenced by the gyrations of the market, aside from escalating impact from economic variables, overall, his portfolio’s direction has not been driven by the ridiculous idea of “ticker based” assessment but from the perspective of portfolio risk distributed allocation!

In Berkshire’s case, 60% exposure to market risks and 40% cash at the start of the year has changed to the direction of increasing exposure in market risk given the present conditions.

Betting Against Warren Buffet’s Oracle?

Figure 2: US Global Investors: Track Record of Warren Buffett’s Major Calls

Mr. Buffett hasn’t been your stereotyped market timer, figure 2 from US global investors shows how the legendary Warren Buffett has incredibly “TIMED” the market with his publicized calls to a near precision or perfection during the past 43 years!

Put differently, Mr. Buffett doesn’t exactly “time” the markets in a literal sense as market technicians are wont to do. His selling call in the late 90s didn’t come with outright liquidation of the entire Berkshire’s portfolio simply because some of his portfolio holdings had been designed as a “buy and hold forever”.

Although he did express some regrets for failing to do so, Mr. Warren Buffett quoted at PBS.org in 2004, ``We are neither enthusiastic nor negative about the portfolio we hold. We own pieces of excellent businesses -- all of which had good gains in intrinsic value last year - but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I.” (emphasis mine) So if the Oracle of Omaha had been subject to regrets, how much more the mere mortals of the investing world?

To reiterate, in periods where he believes markets are conducive for selling Mr. Buffett raises cash in proportion to his allocation targets and positions defensively. On the other hand, in periods where he thinks opportunities for greater returns with a margin of safety embedded on his risk profile, as he does today, he raises his market risk exposure gradually.

Yet, the Mr. Buffett’s rarified but highly prescient audacious landmark calls can be construed from a combination of his interpretation of economic cycles, fundamental valuations and importantly sentiment, the seemingly indomitable “simple-but-hard-to-apply” Buffett doctrine- ``be fearful when everybody is greedy and greedy when everybody is fearful”.

Given his formidable track record, betting against him isn’t going to be a prudent choice.

The Illusion of Bull and Bear Markets

It also to our understanding that gurus don’t see markets the same way ordinary market participants view them, like in the manner which we typically label as Bull or Bear Markets.

Mr. Nassim Nicolas Taleb, the famed iconoclastic author of the best selling book The Black Swan, wrote in Fooled by Randomness ``I have to say that bullish or bearish are often hollow words with no application in a world of randomness-particularly if such a world like ours, presents asymmetric outcomes.” (highlight mine)

Incidentally, Mr. Taleb has been one of the recent exceptions or outliers, whose managed funds have remarkably been up during the recent gore in the financial markets. This from Wall Street Journal, ``Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund.”

While Mr. Taleb’s magic seems to work best with market crashes as he has done so in Black Monday of October 19<sup>th</sup> 1987, he hasn’t been as effective when markets are going up, ``Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility.” (WSJ)

In parallel, Dr John Hussman recently wrote of the pointless exercise of classifying markets as bullish or bearish, ``From my perspective, the whole issue of bull market versus bear market doesn't get investors anywhere. Asking whether stocks are in a bull market or a bear market is like asking Columbus what kind of trees are planted along the edge of the earth. The question itself makes a false assumption about how the world works. My view is that bull markets and bear markets don't exist in observable reality – only in hindsight. What gain is there to investing based on something that's unobservable when you can manage your investments based on directly observable evidence? What we can observe directly is the prevailing status of valuations and the quality of market action.” (underscore mine)

In short, such gurus tend to view markets strictly in the context of fundamentals than from sheer momentum.

Conclusion

To recap, the sharp volatility in the financial markets has been the prevailing trend such that anyone exposed to the market has been subject to losses in the market directly or indirectly.

Even the biggest institutions or the best investors have not been immune from current adverse market developments.

While this is not to justify present losses in the essence of John Maynard Keynes’ famed pretext, ``It is better for reputation to fail conventionally than to succeed unconventionally", the point is to learn from the perspective of übermarket professionals that investing is not about attempting with futility to catch undulating short term waves but of shaping one’s portfolio based on risk distributed time preference profiles amidst observable evidence of market action and fundamental and or economic parameters.

Yet since the prevailing trend of losses has become a mainstream bias, a mounting chorus from value investors seems to have surfaced.

Warren Buffett’s recent contrarian buy calls may have either generated a momentum or provided justifications for the rising incidences of converts (from former bears into current bulls). We formerly listed Dr. John Hussman, Jeremy Granthan and Mohammed El-Erian as the early apostates.

We are adding to our list prominent market savants are Vanguard’s founder John Bogle, Fidelity International’s Anthony Bolton, former Merrill Lynch’s Bob Farrell, Steve Leuthold, Research Affiliates LLC’s Rob Arnott and others.

Even Dr. Marc Faber believes that the low is near but in contrast to the others believes global markets will ``stick at this low point for a long time.”

Yet, some of the rabid high profile hardcore bears whom have basked in the recent glory of market collapse seem to remain stuck with idea of market Armageddon.

But there seems to be one stark difference between the former (converts) and the latter: the former are full pledged money managers while the latter appears to be ivory towered ensconced members of the academia or publishers who aren’t money managers.

Reflexivity Theory: Japan Banks Victims of Prevailing “FEAR” Bias

In George Soro’s theory of reflexivity, the concept basically deals with two way psychological interaction or a feedback loop between the participant’s perception and the situation in which they are engaged in.

According to George Soros, “Financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also the so-called fundamentals that market prices are supposed to reflect in.”

In other words, where the conventional thinking of establishing market prices has been premised on the anticipation of changes in the underlying fundamental conditions of a security or market, on the contrary markets can do the opposite- they can actually shape the fundamentals via the prevailing biases (market momentum).

For instance, the sharp selloffs today, which is the prevailing bias, have brought share prices down enough for some companies operating under regulatory capital ratios to raise capital even when corporate fundamental conditions are healthy.

We are referring to Japanese banks, according to the Economist (highlight mine),

``UNTIL recently Japanese banks had largely avoided the agonies of the credit crunch that had caused such difficulties in much of the rest of the world. Now the misery has well and truly come to Tokyo. The culprit is not toxic derivatives and swaps, but ordinary shares held by banks in Japanese companies. These cross-shareholdings, a peculiar feature of Japanese capitalism, are having pernicious effects. As share prices fall, banks are force to revalue their assets, which in turn reduces their capital ratios. The result is a need to raise capital quickly.

``In the past four trading days, the Nikkei 225-share index has tumbled by 23%. On Monday October 27th the index plunged by 6.4% to 7,162.90, the lowest level in 26 years. Mitsubishi UFJ Financial Group (MUFG), Japan’s biggest bank, plans to raise as much as ¥990 billion ($10.6 billion) by issuing new common shares of perhaps ¥600 billion and preferred securities of ¥390 billion. Mizuho Financial Group and Sumitomo Mitsui Financial Group are said to be planning their own capital increases.

``The government is scrambling to help out. It is poised to announce a set of new measures, including spending perhaps ¥10 trillion to buy shares in companies that the banks hold (in an off-market transaction, so their values do not fall further). This was a tactic used by the Banks’ Shareholdings Purchase Corporation to respond to a banking crisis in 2002. The government may also request that pension funds and life insurance firms buy equities to support the market, though whether they would respond remains to be seen.”

Courtesy of Topix Banking

So what has caused the miseries of the Japanese banks, again from the Economist, ``Share prices are tumbling fast largely because foreign hedge funds have been forced—by the need to meet margin calls and redemptions—to liquidate positions. Investors are also worried that a big global recession will hurt Japan’s exporters, just as a domestic slowdown hurts other firms. Exporters are battered, too, by the steep rise in the value of the yen. It has soared by 11% against the dollar and around 21% against the euro in October, as the yen carry trade unwinds and amid a general flight to safety.”

So global deleveraging has prompted fear which brought upon severe market price distortions enough to require compliance of capital ratios by raising capital of affected companies. And government would now step in to provide assistance. This essentially validates Soros’ reflexivity theory at work.

To consider Japanese banks were thought to be in very a good financial position, such that they were intending to regain international dominance just a few months ago with acquisitions of distressed US financials, to quote again the Economist,

``Just a month ago, fresh from MUFG’s offer of ¥950 billion for a 21% stake in Morgan Stanley, and Nomura’s purchase of operations of the bankrupt Lehman Brothers in Asia, Europe and the Middle East, Japanese bankers felt they were once again dominant on the international financial stage. They were rich with capital and willing to spend, at a time when other institutions were desperate. Now they are victims not of contagion, but of collateral damage.”

So a fear driven market has virtually thrown everything out with the bathwater.

A Fear Driven Meltdown

``A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.”-Warren Buffett, Buy American. I Am.

As we pointed out in Another Grizzly Bear Transforms To A “Cautious Bull”: Jeremy Grantham of GMO former super bear Jeremy Grantham turned bull has been precise about the market’s mean reversions and market overshooting.

This implies that yes, even if the market is already “cheap”, there is that prospect or risk for markets to always overshoot to the downside in as much as markets can overextend upwards. It is plainly called momentum. Since markets over the short term are mostly about emotions, investing today should translate to having a time horizon expectations of at least 12 months.

Take a look at the inflation adjusted chart of the US Dow Jones courtesy of chartoftheday.com

Figure 2: chartoftheday.com: Dow Jones inflation adjusted

The above chart indicates that support levels have broken down from the 2002 levels and could likely see more downside action. This chart squares with the reaction in the Nikkei chart above suggesting for a little more downside action. But from our perspective any ensuing fall could likely signify as a “selling climax”.

Besides, considering the magnitude of the selloffs, it cannot be discounted that markets can always make sharp countercyclical reactions, which means we can’t discount dramatic rebound anytime from now. Yet short term rebounds do not suggest the end of the bear market until the technical picture materially improves.

As Societe Generale’s Albert Edwards recently wrote, ``But cheap(er) markets will not alone generate a rally. The technicals need to be aligned for that to happen. Notwithstanding the forced liquidations now taking place amidst the wreckage of catastrophic Q3 hedge fund performance link, we see the conditions as ripening for a decent bear market rally.” (emphasis mine)

The reality is that markets or even economies always operate in cycles. And the present bear market developments suggest that this has yet to reach its full maturity before a bottom can be found.

So we are delighted to see a growing band of former contrarian bears converting into contrarian bulls. Aside from Jeremy Grantham, known perma bears like Warren Buffet, Dr. John Hussman, Pimco’s Mohamed El-Erian, Societe Generale’s Albert Edwards and James Montier are some of the prominent names that have began to see “value” in markets today.

Figure 3: Pimco: Massive Risk Aversion and Cash Levels

The point is that while none of them is calling for a market bottom, as none of them are known market timers, although they see the present the market activities as opportunities to steadily accumulate in anticipation of future recovery.

They understand that the present fear levels are indicative of near market bottoms as shown in Figure 3 courtesy of Pimco’s Mark Kiesel. Where market psychology has reached panic levels (left) and equally reflected in massive cash hoards (right).

Vanishing Hedge Funds

So what appears to be the source of the present worries?

With many credit spreads seen improving except for corporate bonds, the present concerns have been directed to mainly three areas, namely, hedge funds, emerging markets and fears of global economic recession.

As we noted in It’s a Banking Meltdown More Than A Stock Market Collapse! ``So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.”

The unraveling motions of investor redemptions appear to be in full gear where the $1.8 trillion industry is at risk of substantial contraction. According to a report from Bloomberg, ``U.S. hedge-fund managers may lose 15 percent of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 trillion, a 32 percent drop from the peak in June.” That’s $500 million of asset liquidation if such projections turn to reality.

Some experts have opined that the sheer force from the stampede out of hedge funds may compel governments to even suspend markets. According to another report from Bloomberg, ``Nouriel Roubini, the New York University Professor who spoke at the same conference, said hundreds of hedge funds will fail as the crisis forces investors to dump assets. ``We've reached a situation of sheer panic,'' said Roubini, who predicted the financial crisis in 2006. ``Don't be surprised if policy makers need to close down markets for a week or two in coming days.''

Emerging Market Shoes Drop

Next we have emerging markets.

Countries which had large current account deficits as % to the GDP, those that relied heavily on foreign and or short term borrowing or have been internally leveraged have endured a beating.

Figure 4: Danske Bank: Emerging Market Credit Default Swaps

For instance, Credit Default Swaps which indicates the cost of insuring sovereign debts against a default have spiked for several countries such as Argentina, Pakistan, Ukraine, Iceland, Ecuador, Venezuela and Indonesia as shown in Figure 4 (see right-1 month change of 5 year CDS). This means that the jittery environment has led investors to see higher risks of prospective government default on their debts. Argentina’s proposed nationalization of pension funds seems to underscore such distress.

And the spate of heavy market selling in the currency and debts markets has likewise caused a spike in inflation levels of some EM economies. So while some countries have been suffering from “deflation” symptoms (mostly advanced nations), others are seeing higher inflation rates due to the lack of access to funding and falling currency values. Hence the unfolding crisis has produced divergent impacts and is unlikely deflationary as some contend.

Korea which suffered from a spectacular market collapse last week (Kospi down 20%!) is said to bear the typical emerging market infirmities, according to Matthews Asian Fund ``For many, the collapse of the won is a sore reminder of the Asian financial crisis of about a decade ago. It highlights some of the weaknesses of regional capital markets—bond markets are underdeveloped and there is consequently little long-term funding for corporations as well as an over-reliance on short-term debt. In addition, Korean bank loans are about 30% greater than their deposit base, which means that the banking system has been more reliant on U.S. dollar-denominated funding.”

Although foreign currency rich neighbors of Japan and China have been reported as in a standby mode to provide assistance. In fact, the region is reportedly in a rush to put up a contingency fund ($80b) aimed at assisting neighbors in distress. So it isn’t just a function of IMF doing rescue efforts, foreign currency rich neighbors appear to be doing the same today.

Aside, the South Korean government extended a $130 billion rescue package-guaranteeing $100 billion of external debt and provision of $30 billion loans to banks. Nonetheless, these measures have not prevented foreign investors from rushing into the exit doors.

Figure 5: Danske Bank: Last Shoe to Drop

So not only has the recent credit crunch shrunk the available capital base among international banks, it also compressed investors’ appetite for emerging market investments. The recent outperformance of emerging markets finally phased into contagion side effects (see figure 5). What used to function as a “safehaven” has now caught up with the EM asset class as seen by the huge spike.

Meltdown in Commodity Markets More Fear Related

Given that many emerging markets have been enduring financial and economic turmoil, many see this as telling signs of deterioration in the global economic front enough to justify an across the board selling of commodities as oil, copper and others.

Figure 6: stockcharts.com: Commodity selloffs signs of FEAR!

But the recent behavior in the commodity markets appears to be pricing in a steep global recession if not a depression.

The meltdown has been focused on the assumption of a dramatic decline of global demand. They seem to forget that with the current credit crisis, many of the planned projects will be put on hold or shelved or cancelled, giving way to constriction of supply. If supply falls far larger than the rate of decline in demand then you end up having lack of supply thus higher prices.

Besides, commodities are not the equivalent of opaque and complex financial papers that have triggered this crisis. Commodities essentially don’t go bankrupt.

So even the commodity markets are pricing in more fear than rationality, hence you have an across the board selling of practically all asset classes except for US treasuries and the US dollar.

Albeit we are inclined to think that US treasuries could be the next shoe to drop considering the vast scale of debt issuance needed to bailout the US financial sector and the US economy.

On our part we think that the magnitude of market deterioration demonstrates exaggeration of such concerns, especially seen from our ground levels in the Philippines.

We certainly agree with Mr. Buffett that the deleveraging process has reinforced the fear psychology to the point of excessiveness. And this level of fear means opportunities for him and those with cash.

Moreover, we think that the market, functioning as a forward discounting mechanism, has already factored in the worst outcome and is pricing in fear more than fundamentals.

And when mainstream becomes afraid, this usually denotes of a bottom.