The Changing Role Of Stock Markets: From Market Signal To Policy Instrument

3 charts to explain what has been happening today.

First is that stock markets have been vigorously rallying across the globe. This means that OECD markets have surged but has underperformed emerging markets.


From the Economist, ``STOCKMARKETS in many countries have risen steeply in recent days, buoyed by signals from central bankers in America and Britain that their economies may now be out of recession. Retail sales and industrial production data released this week appeared to support the sunnier outlook for America, helping the Dow Jones Industrial Average to a peak for the year of 9,791 on Wednesday September 16th. On the same day the FTSE 100 reached 5,140, its highest point since the collapse of Lehman Brothers a year ago. The Nikkei is also climbing mostly upwards. However, most stockmarkets have a long way to go to regain their pre-recession levels." (emphasis added)

Next is that while stock markets have traditionally functioned as a forward indicator of the economy, they appear to have been detached from economic reality.

Despite some signs of improvements, some major economic indicators such as foreign direct investments (FDI) have deteriorated in the face of rising stock markets.


According to the Economist, ``FOREIGN direct investment has fallen sharply since the start of the financial crisis, according to the latest World Investment Report from UNCTAD. The purchase of factories, buildings and other assets by foreign firms was hardest hit in rich countries. At its recent peak in the last quarter of 2007, 80% of the world’s FDI went to developed economies, but by the first quarter of this year FDI into rich countries accounted for less than two-thirds of the total. FDI to Flows to emerging economies has held up better.Africa rose to a new record of $88 billion last year, much of it going to countries rich in natural resources. Foreign investment in China and India also surged, as companies sought footholds in resilient economies. (bold emphasis added)

The falling FDI and rising stock market prices suggest that the stock market hasn't been dispensing with its traditional role as forward indicator.

Instead, what appears to be occurring is that global governments and central bankers, especially in OECD economies, have implicitly been using the stock market as an instrument for signal channeling. [see earlier discussion in Governments Will Opt For The Inflation Route]

By tweaking up prices of equity securities, the officialdom hopes to redeem the confidence lost or the "animal spirits" during last year's crisis and stoke an investment recovery.

What we have been getting instead has been rampant speculation and massive misallocation of resources or another bubble cycle.

In short the stock market has transformed from being a market signal to a policy instrument. Hence, traditional metrics under such environment won't operate effectively.

Moreover, another message from the FDI performance is that emerging markets such China, India and Africa have been diverging from OECD economies. In short, the decoupling phenomenon clearly in motion.

Of course all these comes with a cost.

For instance, as the chart above from Bloomberg's chart of the day suggests, rising stock markets from implicit policies to revive the animal spirits translates to a heavy onus on US taxpayers.

This is the result of inflationary policies, aimed at fixing short term predicaments and which benefits certain segments of the society but is paid for dearly by the productive sectors of the economy and by society in general, through the loss of purchasing power or higher prices over the long term.

As Henry Hazlitt once wrote, ``Inflation, to sum up, is the increase in the volume of money and bank credit in relation to the volume of goods. It is harmful because it depreciates the value of the monetary unit, raises everybody's cost of living, imposes what is in effect a tax on the poorest (without exemptions) at as high a rate as the tax on the richest, wipes out the value of past savings, discourages future savings, redistributes wealth and income wantonly, encourages and rewards speculation and gambling at the expense of thrift and work, undermines confidence in the justice of a free enterprise system, and corrupts public and private morals."

The US Dollar Index’s Seasonality As Barometer For Stocks

``Debtors benefit from inflation and creditors lose; realizing this fact, older historians assumed that debtors were largely poor agrarians and creditors were wealthy merchants and that therefore the former were the main sponsors of inflationary nostrums. But of course, there are no rigid "classes" of creditors and debtors; indeed, wealthy merchants and land speculators are often the heaviest debtors.”-Murray N. Rothbard A History of Money and Banking in the United States: From the Colonial Era to World War II

We have been suggesting that the fate of the US dollar will be the key to the directions of financial asset pricing.

In last week’s Gold As Our Seasonal Barometer followed up by a mid week post Gold As Our Seasonal Barometer (For Stocks) II, we offered another contrarian perspective for analyzing the direction of pricing equity securities.

Instead of ruminating over the seasonal effects of September which has been statistically inauspicious for stocks, we suggested to look at gold instead.

Since US dollar has been the traditional and ideological archrival of gold, from which the former today has been continually bludgeoned even in face of some pressures in select asset markets (say in China), and even considering the combined developments in the political and economic front, any selling pressure is likely to be felt in the US dollar than in stock markets, and thus we proposed gold as a seasonal barometer for stocks.

We finally found two charts confirming the inverse of correlation of gold and the US dollar index.

Figure 7: US Global Investors: Inverse Correlation of Gold and the US dollar Index

Mr. Frank Holmes of the US Global Investors noted that ``September is only second to December in terms of dollar weakness, the average result for the U.S. Trade Weighted Dollar Index (DXY)(13) being a 0.66 percent decline from August. Looking at the 39 Septembers going back to 1970, the dollar has seen negative performance 26 times, more than any other month of the year.” (emphasis added)

Of course I won’t deny my “guilt” of looking for information to confirm my bias over my persistent focus on the US dollar.

That’s because it seems quite naïve, for anyone in my view, to believe that events of the last quarter of 2008 will replay itself in terms of a banking system gridlock, the main source of the US dollar’s rally last year.

That’s an old passé story. Society has learned from last year’s banking shock.

Instead, it would seem like an unnecessary distraction, coming from the mainstream macro perspective, still preoccupied with the deflation bogeyman.

Managing Inflation Expectations

What seems to be more of the locus of political attention has been to keep the price level system afloat through the inflation process.

Mr. Axel Merk of Merk Investments hits the nail on its head with his latest commentary, (all bold highlights mine)

``The conclusion we draw from the Fed’s talk about exit strategies and focus on inflation is mostly just that: talk. While we understand why the Fed is talking – to manage inflationary expectations – we believe the Fed may be playing with fire at our expense.

``Indeed, following Bernanke’s textbook, our interpretation is that the Fed may want to have inflation; and to get there, he may want a cheaper dollar, a substantially cheaper dollar. Bernanke has repeatedly stressed how going off the gold standard during the Great Depression jump started economic activity by allowing the price level to rise (read inflation). Fast-forward to today and think about all those homeowners “underwater” with their mortgages. We could allow those who cannot afford their homes to downsize, i.e. allowing market prices to clear by allowing foreclosures and bankruptcies, amongst others; however, that option seems to be political suicide. An alternative is to induce inflation, allowing the price level to rise; the Fed may not be able to control what prices will rise, but seems to be betting on home price inflation.

``Looking at what at the Fed does, rather than what the Fed says, we believe it is actively working on a weaker dollar.”

Indeed, action speaks louder than words!

From Bloomberg, The Federal Reserve ``bought a greater-than-average amount of mortgage bonds for a second straight week, following a period of reduced purchases…Net purchases totaled $25.4 billion in the week ended yesterday, compared with a weekly average of $23.3 billion since the Fed began the initiative in January, according to data posted on the New York Fed’s Web site today and compiled by Bloomberg.”

The US Dollar Carry Trade?

Besides, the selling pressure won’t just emanate from policy induced inflations, but this time it could be compounded from the lower interest rates spreads.

Figure 8: Wall Street Journal: Dollar Now Cheaper to Borrow Than Yen

For the first time in 17 years, Japanese rates have now popped above US rates.

According to the Wall Street Journal, ``On Wednesday, banks seeking dollars had to pay 0.37188%, which is the three-month dollar Libor, while yen borrowers needed to pay 0.38813%. It is the first time since May 1993 that the rates have flipped.” (emphasis added)

Implication? The US dollar could function as a funding currency for a global carry trade.

There have been worthwhile arguments posited against the US dollar as a funding currency due to its huge current deficits, low savings and heavy borrowing requirements since these are likely to induce relatively higher interest rates.

However, for the time being, it is likely that the US could be earnestly trying to attract capital flows into its system to finance its twin deficits by offering its currency for short term asset arbitrages in “target” (high yield) currencies.

Nevertheless even if we could be wrong here, the actions to bring down interest rates to produce inflation (nearly a Swedish nominal negative interest rate policy approach where banks have to pay interest to its central bank for them to accept deposits) simply exhibits how the US dollar remains under heavy strain.

Bottom line: Inflation is a political process. It would be difficult, if not suicidal, to take a contradictory stand against US authorities, when we recognize that the policy thrust has been to use the technology known as the printing press, to achieve a substantially reduced purchasing power for the US dollar.

In short, don’t fight the newly reappointed Ben Bernanke.

Gold As Our Seasonal Barometer (For Stocks) II

Many analyst appear to be giving weight to the seasonality factors.

That's because the scars from the horrid events of 2008 remains freshly imprinted, as we pointed out in Gold As Our Seasonal Barometer

For instance this from US Global Investors,

`` Even as the markets are moving higher and excitement builds, don’t get too carried away. Late-summer trading volumes are notoriously low and this year is no exception. On top of that, money supply data from the Fed indicates negative growth over the past four weeks and the past quarter, which is historically a negative indicator for the equity markets.

``The graph shows the average monthly returns of the S&P 500 since 1970, September is by far the worst performing month of the year with average losses of about 1 percent."

Or this from Early To Rise,

``Research from Georgia Tech: Over a 200-year period, 15 out of 18 stock markets studied posted negative returns in September. From 1970 to 2007, all 18 posted negative returns.

``Consider these facts:

-The last bear market for U.S. stocks began in September of 2000.

-That market hit its lows in September of 2002.

-The Lehman Brothers collapse happened in September.

-The crash of 1987 happened in October, but the decline began in September.

-And the worst month of the great depression? September 1931, when the market fell 30 percent."

Or this new crash alert from an expert who rightly predicted last year's crash. This from Telegraph's Ambrose Evans Pritchard (bold highlights mine)

``After predicting a torrid "relief rally" over the early summer, Bob Janjuah at Royal Bank of Scotland is advising clients to take profits in global equity and commodity markets and prepare for another storm as winter nears.

"We are now in the middle of a parabolic spike up," he said in his latest confidential note to clients.

``"I expect this risk rally to continue into – and maybe through – a large part of August. What happens after that? The next ugly leg of the bear market begins as we get into the July through September 'tipping zone', driven by the failure of the data to validate the V (shaped recovery) that is now fully priced into markets."

``The key indicators to watch are business spending on equipment (Capex), incomes, jobs, and profits. Only a "surge higher" in these gauges can justify current asset prices. Results that are merely "less bad" will not suffice.

``He expects global stock markets to test their March lows, and probably worse. The slide could last three months. "A move to new lows is highly likely," he said."

For all we know they could all be right.

But as we earlier wrote, the fundamental forces behind 2008 and today have been substantially different.

We don't see today's rally as a dynamic emanating from "economic recovery" but from inflationary dynamics.

Second given the acknowledgment by global authorities of the continued fragility of today's economic environment, they are likely to keep the monetary spigot open.

All those issued money from thin air from global governments compounded by the growth in circulation credit arising from the low interest rates worldwide has to go somewhere.

And that somewhere has been in stocks, commodities and Asian/EM properties.

In addition, instead of using the seasonal performances of stocks as the yardstick for predicting a major bear market for turbulent September-October period, I would offer a shift in perspective- the US dollar index as the locus point of a possible major selloff in September-October.

Hence, I would prefer to benchmark gold's seasonal factors as barometer for the stock market. See my earlier explanation here.

Finally we can't discount sharp volatility given the inflationary landscape, but it doesn't mean stocks would crash ala 2008.

Global Stock Market Performance Update: Despite China's Decline, Emerging Markets Dominate

No trend goes in a straight line. That's the fundamental truism of the marketplace.

Yet some analysts have taken China's monstrous 2 week decline as something to gloat on.

True, China has entered the bear market cycle based on the 20% decline technical rule.

But it is unclear that she could suffer from the same fate of the 2008 meltdown. Yet, we won't bet on such idea, especially not when global policymakers have been targeting the asset markets.

Nonetheless here is the updated year to date global performance chart from Bespoke Investments.

From Bespoke Invest, (bold highlight theirs)

``After a 20% decline in a matter of days, China is now just the third best performing BRIC (Brazil, Russia, India, China) country year to date. Russia is up 57.24% year to date, India is up 53.51%, and China is up 52.99%. But it could be worse for China. At least they're not down 50% year to date like Ghana.

``You can tell how much China has sold off versus the rest of the world by looking at its percentage from its 50-day moving average. China is one of just 5 countries that are up year to date and currently trading below their 50-day moving averages, and it is the second furthest below its 50-day (-10.34%) out of all countries behind only Nigeria (-11.97%)."

As we discussed in Global Stock Market Performance Update: Proof of Rotational Effects and Tight Correlations, it has been quite evident that the pricing of global stocks appears to be in rotation, which clearly is a symptom of global inflation dynamics.

Moreover, despite the precipitate 20% decline in China, they remain at the tenth spot among the world's best performers.

China's decline simply brings the BRIC (Russia-7th, India- 9th and Brazil 11th) in a tight pack of the race.

Recall earlier too that Russia fell 30% before rebounding (top window) but has presently been creeping higher. The same actions had been realized in India (BSE) and Brazil (BVSP) but both have recovered strongly.

In contrast, China's rise has been vertiginious or without any major correction since February. So the sharp decline seems much desired, as to normalize its long term trend. The same dynamics seen in its peers are likely to take hold on China's Shanghai index once it establishes a bottom.

Yet regardless of China's recent fate, the BRIC and emerging markets has simply outclassed, by a mile, developed economies, where 9 of the top 20 have been Asian bourses (by pecking order: Indonesia, Sri Lanka, Vietnam, India, China, Taiwan, Philippines, Singapore, Thailand and Hong Kong).

So it would seem like a pointless exercise to gloat over China's recent losses. In horse racing lingo, China's recent decline could be interpreted as part of the "handicapping" relative to developed economies.

Anyway here is the chart (courtesy of Bloomberg) of the world's topnotch equity bellwether-Peru.

If there is anything to be discerned from the above, no trend goes in a straight line.

Bubble Thoughts Over Meralco’s Bubble

``The lies the government and media tell are amplifications of the lies we tell ourselves. To stop being conned, stop conning yourself.”-James Wolcott, American Journalist

Meralco is in the spotlight anew.

The country’s premier utility firm, which holds the exclusive franchise for the electricity distribution for the National Capital Region (NCR), caught the public’s attention following a spectacular record romp by its share prices.

And last week’s parabolic vertiginous ride appears to have been playing out the blowoff phase of a conventional bubble cycle. (see Figure 1)

Figure 1: Bubble cycle (left) and Meralco (black candle right)

Importantly, like typical bubbles, the culmination of which can be identified by delusional rationalizations aided by experts exacerbated by media- Meralco’s skyrocketing price has been attributed to speculations on a prospective ‘tender offer’ (Bloomberg)!

Allegedly one of the titans involved [see King Kong Versus Godzilla at the PSE; Where Politics Trumps Markets] in the drama of the recent corporate joust has acquiesced to a purchase price of Php 300 per share which would require a mandated offering to minority stockholders!

Yet rising prices and some special trades (block sales and cross trades) have been used as signs to confirm on such myths.

Why do we think all these rationalizations seem ridiculous?

Simply said, because logical reasoning has been totally thrown out of the window!

As financial writer and investment speaker Joe Granville warned, ``the media is the biggest enemy of the small investor, mostly headlining the wrong news at the wrong times, playing on his misguided reliance on fundamentals and his normal fears and greeds.”

Putting A Perspective On Meralco’s Price And Corporate Disconnect

To put on some level headed perspective we will deal with some key issues.

First, on a year to date basis, despite the recent turbocharged upsurge, Meralco hasn’t been the only leader with 284.87% of gains (as of Friday’s close).

Other issues like Phisix component mining giant Lepanto Consolidate (+271.43%) and Business Process Outsourcing Paxys (+358.33%) have seen the similar or greater level of share price action as seen in the above chart represented by the green and red lines respectively.

As an aside, I wouldn’t suggest that the latter two would seem in a bubble considering the U-shaped recovery vis-à-vis Meralco’s actions which appear to have replicated the motions of a bubble paradigm as shown in the chart.

Although from a trough to peak basis, Meralco, hands down based from last year, does hold the tiara for market outperformance (700%).

Nonetheless, one must be reminded that past performances are not indicative of future outcomes.

Two, Meralco’s share in the Phisix has now jumped to 7.7% from less than 1%, as we similarly pointed out in Beware Of The Brewing Meralco Bubble!, and now holds the second spot after PLDT in terms of free floated market cap.

This for a company whose profits are constrained by political forces! (see below)

Meralco has effectively, leapfrogged over former heavyweights Ayala Corp, Bank of the Philippines, Globe Telecoms, Ayala Land and SM Investments.

With Meralco’s share of the Phisix gaining more weight, any ensuing volatility from its share prices will likely be reflective on the directions of the Philippine benchmark unless counterweighted by the lagging erstwhile behemoths.

Three, financial valuations, if any of these apply at all, have ENTIRELY been jettisoned for wanton speculations and nonsensical justifications.

As we discussed in Meralco’s Run Reflects On The Philippine Political Economy, the share price movements in the local markets hardly reflects on corporate fundamentals.

The first three factors cited above have clearly been validating our Livermore-Machlup model where Philippine equities move in tidal fashion underpinned by liquidity or loose monetary landscape.

This climate essentially begets a predominant horse racing outlook or mentality, where canards touted as facts mostly emanating from the foibles of cognitive biases.

In short, NO liquidity from loose monetary policies equals NO bubbles, and all the rest are simply footnotes.

As writer Peter McWilliams warned (bold highlights mine), ``The media tends to report rumors, speculations, and projections as facts... How does the media do this? By quoting some "expert"... you can always find some expert who will say something hopelessly hopeless about anything..” Indeed.

Fourth, common sense should dictate to us that perhaps none of these engaged (supposedly cunning and astute) Taipans, whom have built their wealth and “credibility” over the years, would likely pay for excessively or overpriced assets, unless they have other undeclared agenda in mind, which are exclusive of profits meant for the institutions which they represent.

Yet, any outrageous and reckless acquisitions, that would put at risk the interests of such institutions involved, could provoke a minority shareholder revolt. That’s assuming shareholder activism is alive here. Nevertheless, even in the absence of it, we should expect the minority foreign shareholders to vote with their feet.

In short, the supposed buyout, from the alleged stratospheric levels, signifies as tremendous costs to the interests of the company they represent from both the majority and minority stakeholders’ perspectives.

Needless to say, the present day hysteria from rising share prices is temporal in nature and subject to market cycles and does NOT represent the underlying fundamentals. Unless people think that these tycoons are dimwits, I would bet on the opposite…that the so called godfathers involved are cognizant of this!

Fifth, even if the so called buyout does occur, it is less likely that such deal would be consummated in transparency or reflective of market conditions.

These titans could have such transaction wrapped up much earlier than known by the public, or have done so with attendant compromises such as rebates et.al., and could use recent actions as a partial exit point to profit from today’s insanity.

Lastly, as we have been repeatedly arguing, the Meralco brouhaha is beyond the sphere of normal financial analysis because it is a POLITICAL SENSITIVE public listed company.

You can’t just attribute earnings without comprehending on the business model from which the company operates on.

Besides, here, the interests of the owners under the said platform are divergent from the interest of the minority shareholders.

Here is why.

Meralco’s Business Model: From RORB TO PBR

Lately, Meralco’s business model has shifted from Rate of Return Based (RORB) to Performance Based Rating (PBR).

According to GMANews.tv, ``The new PBR scheme also replaces the return on rate base (RORB) formula, which charges customers for using Meralco assets — including posts and cables — in bringing electricity to its end-users.

``Under the RORB, public utilities such as Meralco are disallowed from charging rates exceeding 12 percent of the worth of its total assets.”

So what’s PBR?

According to the same article, ``The new scheme provides “rewards and penalties for performance and non-performance respectively, Jose de Jesus, Meralco president said.

``Under the said mechanism, Meralco may be required to pay fines should its performance — such as failing to immediately respond to a blackout — fall below certain standards.”

And why PBR?

According to the “quasi independent” regulator of Meralco the Energy Regulatory Commission (ERC),

``The ERC adopted the PBR for distribution utilities starting in 2005 pursuant to its authority under Section 43 (f) of Republic Act No. 9136 (EPIRA) to adopt internationally accepted rate making methodologies. PBR strives to achieve a balance between efficient price levels, allowing utilities efficient revenue to ensure their sustainability, and maintaining or improving network service performance levels. It provides strong incentives to improve operational efficiencies. International experience (Australia and United Kingdom) indicates that, over time, with its built-in mechanisms for incentives and fines depending on the utilities’ performance, PBR leads to reductions in the real price of electricity distribution while improving service levels.”

Aside, the ERC has required Meralco to implement a subsidized rates for the poor by the so-called “NEW LIFELINE program, where ``The ERC reiterated that customers consuming only 20 kWh and below shall continue to enjoy the 100% discount granted them and shall pay only the adjusted PhP5.30 per month metering charge, while the other lifeline customers shall enjoy a discount corresponding to the consumption level under the new lifeline program approved under the DTI case, including the PhP21.00/customer/month minimum charge.”

Implications Of The Business Model: Absolute Dependence On Political Discretion!

What ALL of these means:

1. Basically prices charged to the paying consumers of Meralco are solely determined by the ERC and NOT by the markets.

This means that Meralco’s profits are ultimately determined by fickle political winds.

As Ludwig von Mises described of Bureaucratic Management of Private Enterprises, ``But ours is an age of a general attack on the profit motive. Public opinion condemns it as highly immoral and extremely detrimental to the commonweal. Political parties and governments are anxious to remove it and to put in its place what they call the “service” point of view and what is in fact bureaucratic management.”

Think $100 oil. Rising energy prices are likely to stoke political discomfort among the society’s underprivileged from which would force politicians to focus on “windfall profits”.

Yet, in a world where profits will be deemed as inconsistent with political interests, the owners of Meralco will likely wring profits out through other mechanisms, e.g. off balance sheet transactions, loans or contracts to affiliated parties, transfer pricing and etc.

In short, where financial reports will unlikely be transparent, the interests of the owners of Meralco and the minority shareholders departs.

2. Meralco maintains a subsidy for the poor from which are tacitly charged to the account of the middle and high income consumers.

This exemplifies as a “private” company, functioning under stringent control of political interests, conducting the political redistribution aspect in behalf of the government. Hence Meralco acts as a subcontracted implementing agent under political behest.

This implies that economic rents or “profits” for Meralco’s owner managers will only be attained under the auspices of the political leadership for as long as the political interests are served.

3. Under the PBR, the ERC determines the “carrot and stick” for Meralco.

Basically, Meralco’s lifeline hangs on ERC’s dictate!

This implies that the ERC and Meralco will haggle over what comprises as sufficient or inadequate under the PBR guidelines and NOT the consumers.

And since rules are always technically subjective and subject to nonlinear or amorphous interpretations, they will be subject to compromises. Ask the lawyers.

Therefore this implies two things:

One absolute subservience to the political office, where to quote Ludwig von Mises in Bureaucracy, ``Under this system the government has unlimited power to ruin every enterprise or to lavish favors upon it. The success or failure of every business depends entirely upon the free discretion of those in office.” (bold highlights mine)

Second, instead of looking after the welfare of its clients (Metro Manila consumers), the unlimited dependence on the discretion of the government bureaucracy means conflict of interests from parties involved abound.

Principally, the owner’s priorities will mostly be directed into the realm of public relations; of wheedling or currying favor with that of ‘The Powers That Be’. Satisfying the public will requirements will be subordinate to this.

Again from Ludwig von Mises, ``In such an environment the entrepreneur must resort to two means: diplomacy and bribery. He must use these methods not only with regard to the ruling party, but no less with regard to the outlawed and persecuted opposition groups which one day may seize the reins. It is a dangerous kind of double-dealing; only men devoid of fear and inhibitions can last in this rotten milieu. Businessmen who have grown up under the conditions of a more liberal age have to leave and are replaced by adventurers.” (bold emphasis mine)

The sordid and unfortunate experience of the current managers in the besieged Lopez group (who appear to be outgoing****), having to oppose the PGMA administration politically, serves as fundamental and shining example of the consequences of political defiance.

So those nurturing the view that owner-managers of political enterprises will be looking for one dimensional financial bottom line growth are living in a world of fairy tales.

Thus, financial statements have little relevance to Meralco’s valuation as a financial security because economic rents accruing the owner-managers of Meralco may come in sundry forms, than simplistically “profits” as defined by textbooks.

Besides, as pointed out in Has Meralco’s Takeover Been A Good Sign?, the current managing owners of Meralco have to deal with socio-political, bureaucratic and political risks, which ultimately mean that they need to be in constant harmonious relations with the current and forthcoming political leaders.

These are things that are learned outside of traditional or mainstream school curriculums. And yet these signify as unorthodox or contrarian views that operate realistically.

4. The ERC’s leadership is appointed by the President of the Philippines.

This makes the agency hardly independent as purported to be, but instead beholden to the administration.

Again since political appointments are almost always based on political affiliates or interests and are hardly ever about virtues or meritocracy, the direction of regulatory implementation and compliance will likely be dependent on the caprices of the political leadership.

Conclusion/Additional Comments

All these imply that the rewards from the ownership of Meralco comes with the blessings of the ‘Powers That Be’ combined with a possible implied backstop (guarantee) in the case of failure or bankruptcy, provided that the interests of the company’s owner managers or political entrepreneurs operate along the lines of interests of the incumbent political leaders.

Therefore it would be foolhardy or naïve to believe that the tycoons that got engaged in Meralco with billions of pesos of investments, had been there to only leverage on the political misfortunes of the present owners and to speculate on share prices while at the same time ignoring the risks associated with the political aspects of having a stake in Meralco.

Also, this implies that the changing dynamics of the ownership structure of Meralco strongly alludes to the next president-the identity of which only the kingmakers or the chief Meralco proponents know.

****The prevailing notion is that there has been an ongoing power struggle in Meralco.

For me, this seems like an oversimplistic crock.

In my view, both protagonists appear like unheralded allies, only awaiting the appropriate opportunity for a graceful exit for the Lopezes, which I think should come after the elections.

As per Joe Studwell in Asian Godfathers, ``The reality is that tycoons are typically forced to invest together because of the environment in which they operate.” (emphasis mine)

Considering that Meralco’s destiny is fundamentally intertwined with the Presidency, this probably implies that both godfathers could be straddling in support of different candidates in the forthcoming Presidential elections where its outcome will decide who among the two groups will takeover.

Although it is most likely that a price agreement for the prospective exchange may have already been sealed but perhaps at prices much less than the rumors (my guess is anywhere Php 90-120).

Moreover, it has been my inclination to believe that the Meralco saga will unfold similar to the Philippine Airlines privatization, where former PLDT chair Antonio Cojuangco initially fronted for the bidding which ultimately landed in the laps of Taipan Lucio Tan, the current owner.

Finally, of course, both parties would want to see Meralco’s share prices remain elevated, hence through various associates or intermediaries, they might continue to float stories from which the public so eagerly yearns for, as appetizer for their innate speculative instincts operating under today’s loose monetary environs.

However, the idea is-once the political matters have been settled, excess shares could be sold through the markets or that if any contingency arises (such as a dark horse winner in the Presidential elections) both parties can avail of present lofty prices as an exit strategy.

Global Stock Market Performance Update: Proof of Rotational Effects and Tight Correlations

This is an example of how experts use specific time frames to prove a point.

This from Bespoke Invest,

(bold highlights mine)

``The S&P 500 is up 11.24% since July 10th, which is a significant move in such a short period of time. The recent gains also put the index up nicely at 8.28% year to date. As shown below, the US has performed well relative to the rest of the world. Since July 10th, it ranks 22nd out of 82 countries. Russia is up the most with a gain of 24.23%, followed by Hungary, Poland, Norway, Romania, and Germany. Middle and Eastern European countries have seen some of the biggest gains in recent weeks."

Adds Bespoke, ``While China has been the second best performing country (behind Peru) year to date, it is only up 10.32% since July 10th. This is better than most countries, but it hasn't been the worldwide leader that it was earlier in the year. Five of the G-7 countries have outperformed China, and all seven G-7 countries are in the top 50% in terms of performance. This is a sign that developed markets have been holding their own against emerging markets in recent weeks. Only ten out of 82 countries are down since July 10th, with Slovakia leading the way at -5.67%."

We are grateful to Bespoke for their wonderful graphics.

However, with China's year to date gains at a mindboggling 88.66% and with the Shanghai benchmark at grossly overbought conditions, it would be a puzzle or an irony to expect a continuation of such torrid pace of advances or even make a worthwhile comparison. 88% versus 9% (year-to-date) is just a wide wide chasm.

As we earlier wrote in Global Stock Market Performance Update: Rotational Effects and Tight Correlations

``If global markets have been driven by liquidity or monetary forces or inflation dynamics then it is quite obvious that there will be rotational effects and secondly, for the early movers some tight correlation, as global liquidity transmission interlinks divergent markets."

Hence, our views seem to get validated where we appear to be indeed witnessing rotational effects from inflationary policies as the market leadership has temporarily switched from (leaders) emerging markets to the (laggards) developing markets.

Another, as Bespoke likewise observed, only 10 out of 82 since July 10th are down, or 17 out of 82 global benchmarks on a year-to-date basis-signifies further proof of the "global liquidity transmission interlinks divergent markets", we earlier posited. Market gains seem to broadening on a worldwide basis, but not all.

Russia's RTS outperformance appear to be a function of a typical bullmarket trend.

As we commented in the same article, ``Russia's hefty decline exhibits overheating. The Russian benchmark is still the 5th best year to date performer IN SPITE of the recent (21%) downturn. It trails Peru, Sri Lanka, China and India."

Indeed, after a 50% fibonacci retracement since the March lows, Russia has used its recent reprieve and the opportune windows provide by developed markets as fulcrum to stage another gala rendition (even at the face of a mighty performance by developed economies.)

Bottom line: ``developed markets have been holding their own against emerging markets" because of the rotational effects and global liquidity transmission of the global inflation dynamics more than representative of idiosyncratic strength or traits.

At the end of the day, emerging markets has still patently outperformed its developed counterparts under present "ultra loose monetary" conditions.

Asia Sows The Seeds Of The Business Cycle

``All of us are ignorant of most of what there is to know." Professor Richard Dawkins, British Ethologist, Evolutionary Biologist, and popular science author

Anybody arguing that stock markets are strictly determined by traditional fundamental metrics should look at the current earnings environment of the US S&P 500 in figure 1.

Figure 1: chartoftheday.com: Annual S&P 500 Earnings Collapsed!

As you would notice, the inflation adjusted earnings has essentially fallen off the cliff.

According to chartoftheday.com, the ``chart illustrates how earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007, making this by far the largest decline on record (the data goes back to 1936). In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative.” (bold highlights mine)

Yet, with the S&P 500 up 11% over the last two weeks (+8.4% year to date and 43.8% since the March trough), many would probably impute a sharp earnings recovery for S&P component companies, and with it the US economy.

But such rationalization overlooks the obvious.

One, the S&P valuations appear to be priced for perfection.

And most importantly, as discussed in “Should We Follow Wall Street?” and “Worth Doing: Inflation Analytics Over Traditional Fundamentalism!”, stock market prices are increasingly being driven by inflation!

So any analysis which ignores the deepening significance of the inflation component in financial asset pricing would seem like ‘looking at the sun and calling it the moon’.

As Dr. Marc Faber aptly commented in a recent CNBC interview, ``The worst the economy becomes the more governments will print money and people will say, "well, the output gap will prevent inflation from occurring" Do you know what the output gap is in Zimbabwe? 99% below potential GDP and there you have the highest inflation."

This means that as global governments continue to maintain loose monetary policies, which encourages a speculative environment to revive the so-called “animal spirits”, and at the same time undertake expansion in fiscal spending, financial asset prices are most likely to exhibit dynamics which increasingly disconnects with economic and micro-fundamentals or where financial asset prices will detach from popular mainstream economic theories.

And distortions from government policies have always been vented in the currency (see Figure 2) and transmitted to various asset classes.

Figure 2: stockcharts.com: US Dollar Index At Cusp Of A Breakdown

As the US dollar index sags to the point of testing the massive “descending triangle” support level, global stocks (DJW) and commodities (CRB) have been benefiting from the ongoing risk realignment-where money has apparently been shifting away from the US dollar and US sovereigns.

The yields from 10 year US Treasury Notes (TNX) has been rising to reflect on a transition from a deflationary scare and a deep recession to what mainstream deems as “transition to moderate economic recovery”.

However to my mind, the confluence of price signals in the above markets seems increasingly a manifestation of the inflation genie becoming unshackled from the proverbial oil lamp.

With the prospective breakdown of the US dollar trade weighted index, we are likely to witness the acceleration of such inflationary bias.

In his Credit Bubble Bulletin, Doug Noland says it best (bold emphasis mine),

``The problem only seems to get clearer. The maladjusted US Bubble economy is sustained by $2.0 to $2.5 Trillion of new Credit – Credit that must largely be issued or guaranteed in Washington. This reflation (a.k.a. Credit inflation/currency devaluation) drives massive flows to China, Asia and the emerging markets that have few takers other than the central banks. And as economies recover and inflationary distortions reemerge, these enormous dollar flows can be expected to foment increasing policymaker angst. Asian reflation is poised to take on a wild life of its own, forcing policymakers at some point to confront today’s reality that dollar flows are destabilizing and unmanageable. China, in particular, faces tough choices when it comes both to managing its Bubble and accumulating massive quantities of IOUs of deteriorating quality.”

More Evidences Of China’s Bubble Conditions

Indeed, China’s “run away train” markets has significantly been exuding evidences of bubble like conditions [as previously discussed in China In A Bubble, ASEAN Next Leg Up?] see Figure 3, which should pose as a dilemma for policymakers.

Figure 3: US Global Funds: Hot Money Flows And Property Bubble

``The specter of hot money may have re-entered China. An increasing portion of China’s foreign reserve accumulation in recent months cannot be explained merely by trade inflows and foreign direct investment,” observes the US Global Investors, “betting on a strengthening Chinese currency, hot money from overseas added to the excess liquidity problem in China several years ago, and might be used again as another excuse for policy tightening in the future”

Meanwhile, the apparent euphoric mood has enchanted and drawn retail investors into the frenzied punting activities in their domestic stock market, according to Bloomberg, ``Individual investors opened 484,799 stock accounts last week, data from the nation’s clearing house showed today, the most since the five days ended Jan. 25, 2008, and almost five times this year’s low in January.”

And with a savings rate of 49.5% in 2007, according to the PBOC, (WSJ) the shifting of a substantial part of savings into the stockmarket could indeed power up a gargantuan bubble.

Hence, the transmission mechanism from US Federal Reserve inflationary monetary policies seems evident from the standpoint of momentum based international money flows which has bidded up both the stock market and the property market, while domestic policies in China have aggravated the national inflation dynamics.

And this hasn’t been limited to a China only affair.

We appear to be witnessing the same dynamics at work in Asia. As anticipated, Asia’s benchmark bourses saw a mighty succession of breakouts last week from their resistance levels in Hong Kong, South Korea, Australia, New Zealand, Sri Lanka, Indonesia, Singapore, Malaysia and the Philippines.

Meanwhile, Taiwan, Pakistan, Thailand and India are likewise drifting at resistance levels gearing up for the same upside thrust.

A Bank Financed Regional Bubble?

We have argued that low systemic private sector leverage, as represented by the corporate and household sectors, fused with high savings are likely to respond materially to national monetary policies (See figure 4).

Figure 4: ADB Economic Outlook: Asia’s Policy Rates and Bank Lending Growth

The point of our interest in the ADB chart, is that except for Taiwan and Hong Kong which saw a growth contraction in bank lending (upper left window), most of Asia, namely Singapore, Korea, and the ASEAN-4 which includes the Philippines, only saw a moderation- even in the face of the crisis.

Notice too that when ASEAN-4 policy rates had been cut from its peak in 2006 (bottom right window), bank lending growth on a year to year basis zoomed up in 2007 until it crested (upper right window) during the September 2008 Lehman bankruptcy.

Nonetheless, with artificially depressed policy rates as a function of the adaptation of myopic mainstream economics, which had been intended to spruce up consumption or the so called “aggregate demand”, bank lending growth seems poised for an explosive takeoff.

Figure 5: ADB: Importance of The Bank System In Asia

Unfortunately instead of sound investments which should translate to real economic growth, the public’s search for yield will redirect resources mostly to needless speculation.

And since bank lending has been the main credit intermediary for ASEAN (see Figure 5) or even for most of Asia’s economies we are going to possibly see a bank financed regional stock market bubble - where a big portion of the bank lending could be diverted into the stock market in an effort to extract marginal yield.

The Boom-Bust Business Cycle

And so the policy shaped investing landscape had been engineered to lure away the public from savings and into speculation and punting.

Essentially, the seed of business cycles has likewise been sown in Asia as the result of the aversion by global policymakers to face the consequences from previous policy errors.

As Professor Shawn Ritenour rightly argues in When Stimulus Does Not Stimulate (bold highlights mine),

``Artificial credit expansion — credit not funded by savings — creates the business cycle by spawning capital malinvestment. Artificial credit expansion makes many unwise investments (say, in residential and commercial real estate and financial derivatives) look profitable because of the accessibility of cheap credit, so business activity expands, manifesting itself in an inflationary boom. Bad investments, however, are not made economically sound merely because there is more money in existence. These bad investments eventually must be liquidated. The boom resolves itself in a bust whose twin children are capital consumption and unemployment. The moral of the story is that monetary inflation is not a way to sustainably generate economic prosperity.

``One thing the government does do, however, by increasing the money supply is discourage saving. This is because, as prices rise, money saved becomes worth less and less, so people are more likely to spend it on present consumption while the spending is good. Promoting consumption is the last thing we need to build up a capital stock that has been woefully depleted thanks to malinvestment. The old economic saw cuts true: there is no such thing as a free lunch, and there is no costless way to fund government spending.”

Policies that serially blows bubbles have never been sound or productive or generate sustained wealth. Moreover it serves to benefit a privileged few at the expense of the rest of the society.

Nevertheless, in an era of central banking, a policy engendered boom bust cycle is a hallmark feature that must be understood by any serious investors.

This is especially important considering the rapidly expanding role of inflation in financial asset pricing.

And Asian governments are likely to maintain present policies until the financial asset boom permeates to the real economy. From here, this would be interpreted by policymakers as having triumphantly reduced the risks of economic growth recession by reigniting economic growth through artificial credit expansion.

Sadly any perceived growth will be temporary, from where another crisis will emerge in the next few years ahead (2012 or 2013?).

For the interim, Asia’s stockmarket, under the guidance of policy induced incentives, seems likely to power up ahead.