It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

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.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.

Increasing Signs of Pakistan's Depression?

Last July we posted in Does The Violence In Pakistan’s Stock Market Signify Signs of Panic? indications of "panic" from rioting retail investors.

With the Karachi 100 down only about 40% from the peak (compared to others), domestic retail investors appear to have given up hope.

This week's quote reveals much of the rapidly sinking sentiment...

“There are no longer any small investors left in the stock market, they have all been destroyed,” said Kausar Qaimkhani, chairman of the Small Investors Association, leading a group of about 50 shareholders outside the Karachi Stock Exchange. (New York Times).

courtesy of Danske Bank

To consider Karachi's decline has been relatively muted when the country seems faced with a typical Emerging Market "balance sheet crisis" of exploding current account deficits which in times of external turmoil and lack of global liquidity has led to a rapid reduction of foreign currency reserves, sharply rising inflation, swooning currency (down about 30%) , debt downgrade on rising default fears and even fears of national bankruptcy (some have been "cleaning out their bank lockers and dollar accounts" on rumors of the possibility of government freeze on withdrawals). This has been aggravated by a weakening economy and deteriorating political atmosphere.

Pakistan has even approached China to solicit for economic aid. (Who won't? With 1.9 trillion in reserves, China could be the world's counterpart of JP Morgan ,the legendary financier who was credited to have rescued the US economy during the 1907 Panic.).

Nonetheless, all these point towards a near despondency- depression scenario.

Interesting times indeed.

The Bullish Case: It’s Blood On The Streets!

``Many momentous historical developments occur without the participants fully realizing what is happening.” George Soros

It’s been reported that losses in Wall Street has hit $2.4 trillion this week and $8.4 trillion for the year (Forbes) while the Phisix lost some P 554 billion or about or about $11 billion over the week (inquirer.net). On percentage basis, the Phisix lost almost the same as Wall Street down by over 18% and is down 45% year to date against the US bellwether Dow Jones Industrials at 39% and S & P 500 at 42%.

As we have pointed last week, the US seems fast catching up on the Phisix on an apparent race to the bottom. But the optimistic angle for the Phisix, which used to be high beta or “high risk-high return” seem to have transformed into “low beta”. In short, US markets appear to be underperforming the Phisix on the downside as well as the upside.

Yes admittedly the overwhelming power of the global bears eventually did catch up with my “divergence” view from which the Phisix struggled to maintain but eventually succumbed. But nonetheless, if such outperformance manages to hold then come the time when the global markets begin to stabilize or consolidate we should see a faster recovery for the Philippine benchmark.

True, the technical breach from support levels signals the return of the bear market, but it is unclear if we could go deeper.

The optimistic case:

Figure1 BBC: Market Crashes Through The Ages

In Figure 1 from BBC which we have shown in August 2007 and August 2008 highlights the worst performance of the Dow Jones Industrials in terms of one day falls and worst bear markets relative to the scale of losses.

Since each crisis has its own tale, this week’s drop 18.2% is one for the history books (marketwatch.com). Nonetheless, the 7.3% drop last Thursday will be as included as part of the largest one day loss and where the weekly loss looks like the extended variant (instead of one day, it became a one week) of Black Monday Crash of October 19^th 1987.

But from the technical, sentiment, valuation point of view these events are starting to look better.

One, the Dow Jones Industrial’s historical bear markets suggest that the biggest loss EXCLUDING the GREAT Depression has been around 40-50% (right pane) which means unless you believe that the US is faced with the prospects of a great depression, this record loss could herald a near, if not an interim, or even a major bottom.

The Dow Jones Industrials has already exceeded the degree of losses incurred from its 2000-2002 bear market (36%).

Figure 2: stockcharts.com: Fear Index and Capitulation Signals

Next, technical indicators point to severely oversold conditions to the point of ‘capitulation’ (see figure 2) or as per investopedia.com, ``capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.” (highlight mine)

Meanwhile the Fear index (topmost pane), as measured by the VIX is at confounding record highs. In previous occasions, the normal highs recorded were at over 30s (red vertical lines) which coincided with interim bottoms. This extraordinary fear is worth taking note of. Likewise the oversold conditions seem to be corroborated by the Relative Strength Index (RSI), seen at bottom pane, which is at below 30.

Figure 3: US Global Investors: Valuations Halved!

Nevertheless market actions appear to be pricing in a significant slowdown in global economies, according to Frank Holmes of US Global Investors (highlight mine), ``Trailing price-earnings ratios for global equities have been slashed in half since last year, as seen in the chart below. This is true regardless of whether financials are included in the calculation. In October 2007, the Factset Work Equity Index (10) generated a trailing P/E ratio of 18; that has now fallen to nine times earnings.

``Barclays made another important observation: The de-rating has been in response to the deteriorating economic climate. Basically, there’s been a traffic jam of inflation and credit shocks that has generated a global financial panic.”

So from the above perspective, we remember the famous contrarian advise of Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, who reaped a fortune from the ensuing panic during the Napoleon’s Battle of Waterloo as saying ``Buy when there's blood in the streets, even if the blood is your own!” (investopedia.com)

Japan’s Nikkei 225: Back to the Future

In 2003 Japan’s benchmark the Nikkei 225 fell to a 14 year low at about the 7,800 level…

Courtesy of chartrus.com

Nikkei has been on a free fall…

As of this writing the Nikkei is being bludgeoned at 8,300

4 years of gains gone to naught.

Global Central Banks Cut Rates Simultaneously To Cushion Markets!

As we expected, markets under heavy pounding, has prompted SIX central banks to coordinate rate cuts.

chart courtesy of BBC

According to the BBC,

``Six central banks - including the Bank of England - have cut their interest rates by 50 basis points.

``The UK rate move - which had not been expected until Thursday - puts interest rates at 4.5% from 5%.

``The US Federal Reserve has cut rates from 2% to 1.5% and the European Central Bank trimmed its rate from 4.25% to 3.75%.

``The central banks of Canada, Sweden and Switzerland all took similar action in the co-ordinated move.

``The unprecedented step is aimed at steadying a faltering global economy and slumping stock markets.

``The Fed said that it had acted "in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures".

Separately, China lowered its key rate by .27%. Japan didn't participate but supported the move. (Bloomberg)

Earlier today Hong Kong took the lead when it announced interest rates cuts....

``The base rate for banks will drop to 2.5 percent from 3.5 percent tomorrow, based on the U.S. benchmark target rate plus 50 basis points, down from 150 basis points, Chief Executive Joseph Yam said today. The HKMA tracks the Fed Funds rate, which is now at 2 percent, because Hong Kong's currency is pegged to the dollar.(Bloomberg)

Australia likewise took a surprising 1% cut yesterday.

So central banks are using unparalleled modern ways to deal with the unprecedented scale of deflation by using a combination of various tools, aside from tight collaboration and synchronized efforts among themselves. This seems like their version of "globalization" of central bank policies. Although we really doubt if they can be successful in trying to contain the market process of unwinding the excesses of the past. Maybe they can buy some time.

Nevertheless, since rate cuts are effectively growth stimulus, the impact should be different in national boundaries depending on their capital and production structure.

As an aside, central banks today look increasingly desperate and captive to the political demands of Wall Street.

Asia Joins the Panic! Japan’s 1987 Déjà vu; Indonesia Suspends Trading

This is fear written all over.

One, in the US the Fear Index hit record highs and is superbly on the extremes.

Two global markets are in a meltdown mode.

And Asia hasn’t been spared…

Japan's 1987 experience relived...

New York Times ``Japanese stocks suffered their biggest one-day fall in more than 20 years on Wednesday, plummeting more than 9 percent, as fears of the financial crisis and global recession shook markets throughout the Asia-Pacific region and prompted a trading halt in Indonesia.

``The Nikkei 225 index dropped 9.4 percent to 9,302.32, bringing losses for the past five days to nearly 19 percent. It was the largest percentage point drop since October 1987.

Hong Kong shares the same plight…

Worst is in our neighboring Indonesia whose benchmark fell by 10.4%…Where trading has been suspended.

From Bloomberg ``Indonesia's stock exchange halted share-market trading for the first time in eight years after a 10 percent plunge in the benchmark index.

``Trading will remain suspended until further notice, the exchange said in an e-mailed statement. Trading was last halted in September 2000 when a car bomb damaged the exchange building and killed 15 people. Exchange President Erry Firmansyah couldn't be immediately reached on his mobile phone to comment.”

This from International Herald Tribune…``The decline was driven by huge losses in commodities stocks. The index has fallen more than 20 percent in three days, and is off 47 percent since the start of the year.”

The Phisix wasn’t spared to and commiserated with its neighbors. It closed 4.8% lower.

What do all of these exhibit?

The success expectations from concerted government rescue efforts have been now visibly corroding.

Markets are getting to accept the fact that painful adjustments have to be made. Though, probably we can expect more actions from government probably-an emergency RATE CUT by the US Fed as next.

But any bounce can be construed as a “relief rally” from severely oversold conditions.

Of course markets can always overshoot. When the smug from the disaster area clears, markets will likely be more discernful.

Wall Street's Agenda Seem to Dictate on US and Global Policies!

When faced with strong political pressures from the ongoing disorders of social, economic or financial nature, as we said, it is NEVER a question about governments NOT doing anything, but a question public expectations on the outcome of such actions.

Despite the passage of the $850 billion Emergency Economic Stabilization Act (yes Virginia, additional $150 billion on added porks! From Congressman Ron Paul ``In fact, it wasn't until the Senate had a chance to load it up with even MORE spending, when it was finally inflationary and horrible enough, at $850 billion instead of a mere $700 billion, that it passed – and with a comfortable margin, in spite of constituent calls still coming in overwhelmingly against it. 57 members switched their vote!” How Pork Barrels can easily switch votes is not only a Philippine phenomenon but elsewhere like in the US too!), markets continued to display brutal rioting yesterday and today.

So the Fed came up with even more actions; it doubled its auctions of cash lending to banks to as much as $900 billion, announced the changes in debt issuance which reintroduced 3 year notes and began implementing the paying of interest in bank reserves (Bloomberg).

Nonetheless pressures from various influential quarters of Wall Street “suggesting” to them on how to solve the problem. Example, William Gross of Pimco recently wrote, ``We believe that the Federal Reserve must now act as a clearing house, guaranteeing that institutional transactions clear (and investors receive) their Big Macs at the second window. They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.”

From the New York Times today (emphasis mine), ``Under a proposal being discussed with the Treasury Department, the Fed could buy vast amounts of the unsecured short-term debt that companies rely on to finance their day-to-day activities, according to officials familiar with the discussions. If this were to happen, the central bank would come closer than ever to lending directly to businesses.

``While the move would put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.”

Nonetheless as the Bernanke's FED and Paulson's US Treasury deliberate on agreeing into Wall Street's formula to further use taxpayer money to thaw the frozen credit markets, Australia's central bank cut its interest rate benchmark by one percentage point to 6 percent from 7 percent signifying ``the biggest reduction since a recession in 1992, to cushion the nation's economy against fallout from a global credit freeze." (Bloomberg).

Most likely both the "suggestions" of lowering interest rates and FED buying of commercial paper will be effected with the former being a "common policy" adopted by most embattled OECD economies.

It's funny how global policymakers seem to tow the line of Wall Street's elixirs when the latter haven't been able to resolve their own problems, to borrow Kenneth Rogoff's quote on the bailout enactment, ``the central conceit is that government ingenuity can disentangle the trillion-dollar “sub-prime” mortgage loan market, even though Wall Street’s own rocket scientists have utterly failed to do so."

This basically serves as an example of regulatory capture where "a government regulatory agency created to act in the public interest instead acts in favor of the commercial or special interests that dominate in the industry or sector it is charged with regulating." (wikipedia.org )

Hopefully if the US government decides to abide by the recommendations of Wall Street despite the conflict of interest issues, global markets will finally embrace this for good.

Fear Index Pointing To Tradeable Rally Ahead?

Markets are being whacked globally in the aftermath of the combined troubles plaguing the US financial industry, particularly Lehman bankruptcy, Bank of America’s buyout of Merrill Lynch, aside from the capital raising and credit rating of insurer AIG.

There seems to be so much fear in today’s market climate.

One of the popular measure of Fear is the VIX index as defined by Wikipedia, ``VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.”

During the past year each time the VIX spiked beyond 30, the markets tend to temporarily bottom and usher in some short term “rebound” as shown below…

The blue vertical lines point to the historical “peaking” activities of the VIX index.

The temporary bottoms which it coincides with have been followed by rallies as shown by the trend lines of the S&P and the Phisix. But the important point is that the scale of past rallies have differed, of which is a very important determinant of the viability of the trade proposition.

Bottom Line: Further selling pressures could translate to “short term trading windows” for the Phisix. At the risk end, these may seem like "catching falling knives"; but given a longer term perspective, opportunities seem to present itself as buying at fire sale levels.

Focusing On The Future: the Phisix and the Philippine Presidential Cycle

``The typical US investor tends to have about 80 percent of equities in the US. The world of tomorrow suggests a much greater exposure overseas. In general, you should consider holding a third of your equities in the US, a third in industrial countries outside the US and a third in emerging markets.”-Mohamed El-Erian, When Markets Collide: Investment Strategies for the Age of Global Economic Change, co-CEO of bond-investing giant Pimco

Self development author Robert Ringer cites the work of the late Alvin Toffler in the landmark book, the Future Shock, where Mr. Ringer wrote, ``Toffler believed that at any given time in history, about 90 percent of the population thinks in terms of the past, 7-8 percent have their heads in the present, and 2-3 percent are focused on the future.” (highlight mine)

Applied to the markets, since only 2-3% think in terms of the future while 97% are merely trend followers or momentum players then getting “ahead of the curve” translates to focusing on the possible outcomes in terms of the future and positioning ahead.

Getting Ahead of the Curve: Focus On The Longer Horizon

Thus to be able to acquire such an edge we need to understand how to use information. Josh Wolfe of the Nanotech section of the Forbes magazine tells us of the three sources that we need to focus on:

From Mr. Wolfe (underscore mine),

``Remember this: there are three sources of edge for you as an investor: informational, analytical or behavioral. Having an informational edge—a legal one at that—is very hard today because bits of information are distributed (via bits of optically propelled 0s and 1s) faster and wider than ever before. If the world is flat then information spreads across it (through Cisco routers) with nary a ripple (like Crisco on a pan). And sad but true: those lacking assets connecting them to info (logins, laptops, and lit fiber) lack assets connecting them to investors. You need basic infrastructure for basic trade and e- infrastructure for ETrade.

``Now “analytical” edge is more valuable than informational edge because fewer have it. Scarcity has value. You and I can get the same information but I can analyze it differently, attributing different meaning and weight the duration or magnitude of information or expectations differently. Maybe I can analyze it better. But more investors and more funds means more efficiency and less edge. And many market players competing to surgically excise (and analyze) truth from information means you get paid less to be a “surgeon” in the stock market ER.

``Know this: the best way to have analytical edge is to have a longer time horizon than the rest of the market. If the market discounts intrinsic values to the quarter, having a variant perception a year out can help you find undervalued stocks. My friends at Fund-of-Funds say so. Yet, shockingly: they do as they do not as they say. They manage their hedge fund managers to the month (with monthly reporting)—the unintended consequence? Their hedge fund managers shorten their own time horizon to manage against redemptions and fund withdrawals—inadvertently eroding away their edge. But alas, lamenting “short-termism” seems to be the only long-term rant that stays the course.

``Thus behavioral edge is the one remaining true source of edge. Edge can come from understanding social psychology, the madness (or wisdom) of crowds and individual cognitive and behavioral biases. If you guessed “none” instead of “nine” you thought appropriately more like a sociologist than a mathematician.

In essence, Mr. Wolfe suggests to us to have access to the right information by having the appropriate infrastructure, to know how to process such information by adequately analyzing them in the context of the big picture and to understand social psychology and the cognitive or behavioral biases to take advantage of market sentiment.

The Phisix And The Philippine Presidential Cycle

For instance 2 years from now the Philippines will undergo another national political exercise known as the Presidential elections.

While much of the public have been speculating on who will be running under what party, we are interested to know how the Phisix responds to the election of a NEW president as shown in Figure 6.

Figure 6: Presidential HONEYMOON

The blue arrows in Figure 6 demonstrate of how the Phisix responded during the last 3 Presidential election years which spanned over the past 22 years or since 1986. All of them have been positive.

In 1992, when Fidel V. Ramos assumed the presidency under the bull market cycle of 1986-1997, the Phisix soared from about 1,100 to 3,200 in 1994 (about 190%). Of course this didn’t happen in a straight line. 1992 had a mid year correction but the HONEYMOON prompted bullmarket was jumpstarted anew when the New Year ushered in.

1998 was a baptism of fire for Joseph Ejercito Estrada, having been elected to the presidency a year after the Asian Financial Crisis imploded. The Phisix responded with a late but fierce HONEYMOON-Technical oversold bounce which resulted to a gain of about 127%. Unfortunately, because the bounce signified as a countercyle amidst a secular downtrend, the advances were momentary and lasted only NINE months.

The controversial reelection of the incumbent president Gloria Macapagal Arroyo came amidst the backdrop of a booming global equity markets. The Phisix jumped from around 1,430 in April to 2,130 in February 2005 for a 48% gain in less than one year to reflect the GMA HONEYMOON.

However, 2005 saw the US dollar stage a massive rally amidst another political controversy which hounded the presidency-the Hello Garci Scandal, thus the Phisix traded sideways for most of the year until the last quarter.

By 2010 Global Markets Could Be In A Recovery Phase

Of course, we should mull over on whether the external environment would be supportive of such HONEYMOON. On whether the banking crisis in the US would have been on a mend or if it could still be undergoing adjustment pangs as shown in Figure 7.

Figure 7: PIMCO Emerging Markets: Average Crisis Durations

According to Michael Gomez, Executive Vice President of leading global investment management company PIMCO in a recent article, ``Unfortunately for the U.S., the fallout is usually both lengthy and costly: historical evidence suggests that banking crises in developed countries take, on average, between four and five years to resolve. As Yogi so famously said, “It ain’t over ‘til it’s over.””

If we are to base the present crisis from the inflection point of the US real estate sector, then the reckoning period for the advent of the crisis could be pegged at February of 2007, see Figure 8.

Figure 8: stockcharts.com: US Real Estate Led Crisis

The NYSE Real Estate index (main window) turned nearly a quarter before the Dow Jones Financials (top minor pane), Banking Index (mid minor pane) and the Mortgage Finance Index (lowest pane).

So if it should take the average crisis in the US to be settled in a timeframe of four to five years, then 2010 would already mark the late phase of the crisis which could translate to a bottoming or consolidation of the US equity markets. At best, it could also start to exhibit some signs of recovery!

Another, if it takes 3.7 years for all countries to resolve the present crisis and 3.3 years for emerging markets based on the PIMCO studies of banking crisis, then it also means that most of the world economies would also be on the process of a recovery by 2010!

This posits for a possibility of strong kick during the presidential honeymoon phase, which also means that 2009 could translate to a springboard for a powerful presidential honeymoon cycle momentum in 2010.

Overall, the prospects of a recovery in the Phisix looks likely a sooner than a later proposition.

Crash and Meltdown Alerts

However, as a word of caution these three months are likely to reflect the most vulnerable months of global equity markets. Some institutions like the Royal Bank of Scotland and Morgan Stanley have issued crash or meltdown alerts last June.

It is not for us to agree or not with such dire outlooks. We have spilled so much ink on these horror stories. While I don’t share the outlook, it can happen. The important thing is to observe HOW OUR PHISIX WILL REACT if these events do occur and not to run to the hills to seek refuge.

At the interim, if the PRESENT DIVERGENCES in the Phisix-US/global markets CONTINUE TO MAKE A SIGNIFICANT HEADWAY even amidst the prospects of a “perfect storm” then investors could possibly start to price in with confidence the belief that we could depart from the rest of the global markets affected by the debt bubble bust stigma.

The best is to see the Phisix consolidate with an upside bias on a gradual scale regardless of what happens elsewhere. A sharp upside climb risk a volatile and deep decline that could wipe out all gains accrued. A good example would be President Estrada’s honeymoon.

Thus, we should see a meaningful yearend rally to mark the transition from the bottom towards a recovery probably from mid October thereafter-assuming no major crashes to impact us. Then 2009 should see a marked improvement from 2008.

On the worst outlook, a global crash could possibly bring our call for this bottom phase to a test.