Hedging On VIX Futures Indicates Of Growing Imbalances?

The anomaly du jour appears to be rising tensions from policies applied versus the natural state of the markets.

The important thing one needs to know is that, has there been pressures from such tensions building underneath?

This from Bloomberg

(bold emphasis mine)

``Investors are guarding against renewed volatility in U.S. stocks even though a so-called fear gauge shows they have overcome the panic resulting from last year’s credit crunch.

``The VIX index, an indicator of expected swings in the Standard & Poor’s 500 Index, closed yesterday at its lowest level since Aug. 29, 2008. The VIX fell 6.9 percent to 20.69, about half a point above its average since the Chicago Board Options Exchange’s calculations began in 1990.



Again from Bloomberg,

``As the CHART OF THE DAY shows, though, the gap between the index and VIX futures is wider than it was almost 14 months ago. The contracts closest to expiration settled yesterday at 23.65, or 2.96 points higher than the index’s value. The differential was just 1.05 points at the end of August 2008.

“Heavy hedging activity” accounts for the wider gap, according to a report yesterday from McMillan Analysis Corp.’s Option Strategist Hotline. The VIX itself has to surpass 24 to signal an increase in stocks’ volatility, which tends to occur when prices fall, the report said.

``The VIX, more formally known as the CBOE Volatility Index, has tumbled 74 percent from last year’s record close. The gauge peaked at 80.86 on Nov. 20, 2008, when the S&P 500 fell to its low for the year."

Additional comments:

Inflationary policies are inherently unsustainable. At the onset inflation has been mainly an asset dynamic.

Nevertheless, policies can lead to the furtherance of inflation (and a diffusion) from which may translate to the extension of today's aberration.

On the other hand, market forces could unravel on the mounting imbalances when inflationary measures can't sustain its levels.

Hedging in the marketplace appears to be looking forward at the latter scenario for 2010.

Anyway, a valued reminder from John Maynard Keynes on mainstream expectations of "desperately seeking normal", ``The market can stay irrational longer than you can stay solvent."

Why An Increasingly Asset Friendly Environment Should Benefit The Phisix

``There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it.”- Jeremy Grantham Reinvesting When Terrified

The risk environment seems to be tilting towards an increasingly cash hostile-asset friendly environment from which the local stock market would likely benefit from.

Here are six reasons why:

1. Extremely Depressed Mainstream Sentiment.

After a 55% drop in the Phisix from its peak in October of 2008, the public still sees the equity market as highly “risky” in the “traditional” economic sense (more below).

You can just see this overwhelming dire sentiment in news headlines or TV news shows or from the viewpoints of media’s favorite talking heads. This runs starkly opposite to the dominant sentiment when the Philippine benchmark was at 3,800 when there was a cheery consensus (except for us).

In other words, overtly depressed mainstream sentiment (or sentiment extremities) conveys of nascent signs of a possible inflection point.

2. Creative Destruction

After a staggering $50 trillion loss of global financial assets from which one fifth or $9.6 trillion has been ascribed by the Asian Development Bank to Asia (msnbc.com), a recognition of global recession and the collapse in global trade, investment and financing or deglobalization, such colossal downsizing of financial assets and the massive retrenchment in the global macroeconomic structure, for us, signifies as “creative destruction” which may have reached a near culmination of the process in many parts of the world. Possibly with the exception of the US and parts of Europe.

3. Perspective Shift from the Macro to Micro environment

Despite the latest globalization trends, since the world isn’t “entirely” integrated, where much of the external linkages have been only from the aspects of labor (remittances), trade, finance and investments, the significant market attention on the macroeconomic framework during this adverse adjustment period is likely to shift weight towards to the micro landscape [see Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?], thereby possibly leading to more signs of “divergences” or “decoupling”.

4. Policy Incentives Are Directed Towards Aggressive Risk Taking

Of course, we have to admit that the healing process from today’s major drastic economic shakeup will translate to a time consuming effort or that resource or capital reallocation essentially takes quite a time.

But this doesn’t mean markets can’t progress especially when global policymakers have been working feverishly to impel incentives favorable to risk taking.

One, global central bankers have been squeezing down interest rates nearly to zero…

From Morgan Stanley’s Joachim Fels and Manoj Pradhan (bold highlights mine) ``. Within the G10, official interest rates are virtually zero in the US (0-0.25%) and Japan (0.1%) and just 0.5% in the UK, Canada and Switzerland.

``In the euro area, the refi rate still stands at 1.5% after last week’s cut, but the effective overnight interest rate (EONIA) between banks trades close to the 0.5% floor set by the ECB’s deposit rate. Thus, the GDP-weighted G10 policy rate now has a zero handle. The weighted G10 policy rate is likely to drop further as we expect more rate cuts in the euro area, Japan, Australia, New Zealand, Sweden, Norway and Switzerland in the next few days, weeks or months.”

Next, they’ve also been monetizing debt or printing money…

Again from Fels and Pradhan ``several major central banks including the Fed, the ECB, the Bank of Japan and the Bank of England are engaged in various forms of quantitative easing, which has led to an explosion of excess reserves held by banks with these central banks. The explosion of bank reserves has pumped up the monetary base – consisting of cash in circulation plus bank reserves held at the central bank – in these four countries, as we have illustrated. In the US, the monetary base has more than doubled over the past year, while it is up by 40% in the euro area and 30% in the UK over the same period. The monetary base is also called ‘high-powered’ money, because our fractional reserve banking system allows banks to create many times the dollar amount of deposits from the monetary base through lending to, or acquiring assets from, non-banks.”

It is not much different here in the Philippines see figure 1.

Figure 1: Danske Emerging Market Briefer: Philippine Negative Interest Rates

At least in terms of the interest rate regime, the Philippine overnight borrowing rate has been fixed presently below the (CPI) inflation level by the Bangko Sentral ng Pilipinas (BSP), which makes the domestic interest rate environment essentially negative- net losses for savings compels the public to stretch for yields, which makes the marketplace conducive for speculation.

Furthermore, since the Philippine economy has negligible exposure to leverage, where the underlying risks from the evolving crisis has so far been “marginal” and limited to the external nexus, policies have been mainly directed at the interest rate and fiscal “safety nets”. In other words, no Quantitative Easing required, which should be a strong case for the Peso.

Table 1: IMF: Distribution Share of Global Stimulus Package

Finally global governments have been applying huge-but according to IMF and other ‘Keynesian’ economists-inadequate-doses of fiscal stimulus programs (see table 1) in an attempt to offset growing slack in the global economy.

Figure 2: Ivyglobal: Size of Global Bond Market

With over 75% of the global debt markets, see figure 2, held by the overleveraged economies in the US and Europe, this means that these coordinated measures appears to have been also targeted at “reducing the real debt levels” mostly held by the private sector.

So to rephrase, despite the repeated promulgated goals by global governments to induce “normalization” of credit flows by various ways to replace lost ‘demand’ mostly via government spending, the combined actions of lowering of interest rates, coordinated “various forms of quantitative easing” and massive infusion of fiscal stimulus can also be construed as inflating away debt levels.

What does this imply?

The gradual metastasizing of the risk environment from one characterized by economic recession to one where global currency values are being deliberately debased seems to be intensifying. This increases the opportunity costs of holding cash. And the effects are likely to be felt first in parts of the global asset markets. But there isn’t going to be a revival of the securitization-financial structured-shadow finance markets, the source of the bubble bust though.

5. Signs of Improving Trends in the Marketplace.

We may have begun to witness signs of selective recovery in several asset markets.

There has been significant progress in the technical pictures of primary commodity markets such as oil, copper, gold and the Reuters-CRB index or in the general commodity markets. Importantly the advances in the commodity markets have equally been reflected on Baltic Dry index, a cargo freight weighted index, and several key credit markets.

Moreover, there was an explosive upside action in most of the global equity markets last week.

Figure 3 stockcharts.com: Oversold Bounce

While this huge bounce appears to have been mainly a function of severely oversold conditions, see figure 3, it is important to note that Emerging markets (EEM), at the topmost window, have led the bounce earlier relative to major markets in Asia (DJP2-ex-Japan), European (Stoxx 50) and the US S&P 500.

From the technical perspective since the US S&P 500 have widely departed from its 50-day moving averages, hence, like an overextended rubber, snapped back vigorously.

We are skeptical yet of the US and key European markets as having hit the milestone “bottom”. Material progress in the technical picture, which requires some additional time to reveal on its maturity, plus signs of some economic improvement could serve as key indicators for a turnaround. Besides, the mayhem in the financial sector hasn’t been resolved. But for now, these markets appear to be working off overstretched conditions.

Nonetheless, the oversold bounce, which could probably last 1-2 months, could likely help boost general market sentiment even temporarily. And the progress in general sentiment could function as the necessary fulcrum for an extended and substantial improvement of the technical picture of the relative outperformers, mostly found among Emerging Market bourses, enough to cushion them into the next possible wave of decline.

For instance, the Philippine Phisix, which appears to be in a bottoming process, could be jolted out of its consolidation phase and segue into the early stage of the advance phase of its market cycle.

It could possibly do a Taiwan, whose key bellwether the Taiex index, a surprising outperformer, which appears to have broken out of the consolidation phase on the back of a fantastic 3-week run, even prior to last week’s general recovery in the global equity markets. The Taiex is up by about 17% from its lows last November and is up 6.6% over the year with the gist of gains coming from last week’s 5.24% romp.

6. Phisix: Learning From Market Cycles

In our July 2008 edition, the Phisix: Learning From the Lessons of Financial History, we identified the scalability of the typical bear market cycle for the Philippines.

Since the activities of today’s domestic bear market cycle reflects on principally the global contagion effects from last October deleveraging or “forcible selling” process more than economically prompted, we seem to have accurately read the dynamics where an easing of foreign based deleveraging motion will cease to hemorrhage asset values in the Philippine markets.

And indeed as the share of foreign trade has contracted and where net foreign selling has materially diminished, [see Phisix: Braving The Global Storm So Far], the Phisix appears to have been in consolidation or appears to have been reinforcing this bottom formation dynamics for about 5 months now.

Besides, with the Phisix having to touch losses of 55% late last year, it is has nearly reached its conventional bear market range of retracement of 60-66%. To consider, this bear market hasn’t been “internally” (domestic or regional) generated but instead from contamination overseas. Hence, its recovery will likely be fortified on signs of the more participation from the region’s bourses and from signs of improvements in the national economies in the region.

Together with some developments in the corporate world, the windows for risk taking either for the long term or for the short-term outlook seem to have opened. It is time to take advantage of it by nibbling on the market either by trading or taking long positions or both.

Has the Reverse Invisible Hand Been Responsible For The Dismal Performance of US Equity markets?

The US markets is on a milestone…a milestone low.

And Chart of the Day tells us ``The Dow is currently down 53.4% since peaking in October 2007. To put the magnitude of the current correction in perspective, today's chart illustrates the 15 worst corrections of the Dow since its inception in 1896. As today's chart illustrates, the current Dow correction already ranks as the second worst on record. Only the correction that began in 1929 was worse.”

While we often resist the temptation to attribute market movements to politics, this observation from Bespoke seems worthy to contemplate on.

From Bespoke Invest (bold highlights mine), ``While Washington has lauded the $787 spending bill as the medicine that will help bring the economy out of the recession that President Obama 'inherited,' the market is taking a different view. Consider this -- since the spending bill was passed by Congress on February 13th, the S&P 500 has lost over $1.8 trillion in market cap, which is over twice the size of the plan signed into law! The question for economists now is whether or not the positive multiplier effect associated with the spending bill will be enough to offset the negative multiplier effect from the proportionately bigger decline in the value of US equities in the pension funds, IRAs, 401k's, and investment accounts of Americans.”

Is this merely a coincidence? Or is the market signaling disapproval on government's action? The market losses have apparently been greater than the stimulus packages drawn up by the US government.

More from Bespoke, ``As shown in the chart above, during the first few weeks of President Obama's Administration, the Dow was rangebound with a slight negative bias. It wasn't until the stimulus bill was signed and the budget unveiled that the bottom fell out of the market. Since Inauguration Day, the Dow has declined 1,686 points (20.4%). Of those 1,686 points, 1,253 have come since the passage of the stimulus plan. While there are certainly plenty of other issues weighing on the market, it's hard to argue that the "stimulus" and budget proposal haven't had a negative impact. While the Bush Administration was criticized by investors for lacking clarity in its policies regarding the economy, Wall Street clearly is not comfortable with the actual clarity coming out of Washington today.

``With a 20.37% decline since Inauguration Day, the Dow's performance during President Obama's Presidency already ranks as the third worst among US Presidents since 1900.”

We saw a media jester convey a message in a show that markets don’t accurately reflect on people’s sentiment. That’s plain hogwash. People can say something but do the opposite. On the other hand, we suggest that markets reflect on actual votes-in terms of money in or out of their wallets. It signifies something like “people voting with their feet”.

Besides the US markets have nearly half of its populace exposed to the financial markets.

ICI estimates that some 52.5 million, or 45.0 percent, of households in the United States owned mutual funds.And the biggest share as shown above is in the ownership of stocks.

And likewise the US census estimates that 50.3% of households had exposure in stocks in 2005.

With the torrent of bailouts and or stimulus money thrown to rescue several companies in a funk, the Nasdaq OMX has created last January 5, “The Government Relief Index” meant “to measure the performance of the 21 stocks that received at least $1 billion in emergency government funding, is down a whopping 58 percent.” (US Global Investors)

This perhaps could be seen as another sign where markets appear to be refusing the endorsement of the hodgepodge of government sponsored programs which in essence marks a reversal of the invisible hand.

Which brings to fore a fitting quote from Peter L.P. Simpson posted at the Mises Blog,

``There is, one might even suppose, a reverse invisible hand at work. The free market is said to produce order and success as the unintended result of many producers and sellers and buyers independently pursuing their goals. So the controlled market seems to produce chaos and failure as the unintended result of many voters and politicians and bureaucrats independently pursuing their goals. Unlike the invisible hand of the free market, the reverse invisible hand is not benevolent. It is malign. It is the chief cause of economic booms and busts and of the accompanying delirium and distress where outrageous profits jostle alongside outrageous losses.” (bold highlight mine)

Phisix: Understanding Benchmarks; Tidal Flows and Ebbs

``I don't set trends. I just find out what they are and exploit them." - Dick Clark, American Entertainer

Recently we were asked why we chose 2,650 as our threshold benchmark for a transition to a bottom cycle than 2,600.

Figure 5: stockcharts.com: Phisix Does This Like A Recoupling?

Our reply is that trend lines can be deceptive. Look at figure 5, the green line (1) was the original downtrend line, when the Phisix made a first attempt to bottom out in May- unsuccessfully (red circle). Thus the high from that failed breakout becomes our beacon or our lamppost to suggest of the transitioning from the current phase (bottom) to the next phase (advance). That benchmark is about 2,900.

The next blue line (2) signifies the second downtrend line at 2,600, which we thought acted as a minor resistance with the most recent high at 2,650 (blue horizontal line) or a margin of 50 points as enough cushion for false breakouts.

Well the Phisix performed exceptionally well this week. Our benchmarks were significantly overrun. All downside jolts from the US markets have been met with a shrug or insouciance. However the upside was treated with even more dazzling sprints. Plainly said, the Phisix disregarded significant downside moves in the US markets but outclassed them when they moved up. Our Phisix hasn’t behaved like any of the recoupling rubric as proclaimed by the macro looking market and economic Jeremiahs. Not yet anyway.

In fact, the Phisix appeared to have acted out the script we presented last week in Phisix: Knocking At The Exit Gates of the Bear Market!...to a tee!

Moreover, the Phisix strongly outperformed the US market up 4.2% backed by strong broad market activities. Considering that the US closed significantly higher last Friday, we are likely to see a strong opening on Monday.

True, foreigners remain net sellers but they have been reduced to a significant minority (44% week on week) as local money has now dominated the upside action. If the forcible liquidation coming from abroad has diminished thus it is understandable for the locals to take on the destiny of Phisix on their own hands. It is HOME BIAS working at its finest (for the year and since October of 2007) so far.

In short, compared to May, today’s rally seem have stronger legs which should imply what we have been looking for- a transition cycle.

For the bottom phase, we expect one of the two scenarios: one a consolidation or base formation, or two, gradual ascension. If the Phisix should move abruptly higher we might see a sizeable retracement but the recent lows or the former resistance now support should hold, if we are correct about the market in a bottom cycle. And in a bottom the appropriate action would be to accumulate on issues to position for a recovery.

By the way we shouldn’t expect so much for this cycle. The Phisix is still faced with severe external risks, and could be weighed by storms from shocks. Nonetheless, a bottom suggests of a base in spite of the tempest. Anyway, our idea is that if some markets in Asia can pick up in as much as the Phisix then a potential recovery is in sight.

Some have asked me on what issues to buy.

Allow me to quote my favorite from Edwin Lefevre from the classic book Reminiscences of a Stock Operator, ``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Proof? Look at Figure 6.

Figure 6: PSE: Sectoral Indices In Synchronized Actions

According to Mr. Edwin Lefevre (a.k.a. Jesse Livermore) “In a bear market all stocks go down and in a bull market they go up...” All industry indices have performed almost in sync-bank-blue, services-gold, mining-black candle, commercial-maroon, property-red, and holding green-from bullmarket to bear market to the recent turnaround.

Of course one may argue that one industry could outperform the other. That is true. But generally speaking, they flow or ebb like a tide on the beach.

The last bear market saw almost all stocks fell beyond the 20% threshold bear market levels, except for a few which we identified in Phisix: Learning From the Lessons of Financial History.

If we are right about the Phisix’s new cycle, then the next cycle should see the same characteristics.

First Test of the Phisix Bottom Thesis: Passed With Flying Colors!

``The true prophet is not he who predicts the future, but he who reads history and reveals the present.”-Eric Hoffer, 1902-1983, American social writer

So far so good.

My suspicion that the Phisix could have probably entered into a bottoming phase encountered its first acid test and appears to have passed with flying colors. In the face of pervasive gloom and doom, the Phisix cautiously bounced back by 2% this week for the first week in five.

Interpretation of Initial Impact and Arguments For A Phisix Bottom Redux

Of course the market’s reaction can be interpreted in two ways;

one- a short term interim technical bounce amidst a persistent medium term bear market or

second- an interim bounce which paves way for a seminal bottom under the perspective of its long term underlying trend. Remember market cycles involves process transitions and is not merely event-driven as incredibly suggested by some “experts”, therefore, the Phisix would have to pass repeated tests in order to reconfirm the validity of the ongoing restoration of confidence process.

We have premised the potential turnaround on a confluence of factors which involves the following:

1. Market volatility.

The recent gains of the Phisix (2.8 times) have not been steep and sharp enough as to merit a similar scale of descent. As an example, in 1986-1987 the Phisix climbed by about 10 TIMES which was correspondingly met by a nasty 50% correction. Similarly as mentioned last week, Saudi’s Tadawul and China’s Shanghai bourses flew by over 5 times in TWO to THREE years and has met by the same degree of volatility on its corrective phase, 65% and 50% respectively. Paraphrasing Newton’s Law, Every action has an almost equivalent and opposite degree of reaction.

2. Bubble cycle.

Every asset classes in today’s paper money driven world have been driven by varying stages of massive credit and monetary expansion. Based on public participation we have not seen evidence of such euphoria or investor irrationality.

Next, our asset markets have not reached extensively rich valuations levels. Lastly, the country’s macro or micro indicators have not signified signs of excessive leverage.

3. Encompassing Negative Sentiment.

Since market activities are driven by the investing or speculating public making decisions for whatsoever reasons- they involve psychology. Thus, market cycles are primarily underpinned by the psychological cycle.

Given today’s dire headlines from the domestic front (rice crisis, government threat of a utility takeover, etc.) to overseas (US recession, world economic slowdown, continuing credit crisis, surging “inflation” in food and energy, etc.), the degree of risk aversion has somewhat reached overshoot levels. Yet actions in the marketplace do not reflect or have not been congruent to the same degree of anxiety as shown in Figure 1.

Figure 1: stockcharts.com: PSE The Outlier!

As global markets have remained as closely correlated as in the past, most of these benchmarks imply that the underlying national indices under such rubric have rebounded since March of this year (vertical line).

The Dow Jones World Market at the top pane, the Dow Jones Asia Ex-Japan Index (below center window) and the iShares Emerging Markets (lowest pane) have recovered substantial losses since October.

Whether this recovery represents a “dead cat’s bounce” or a “bear market” rally is arguable and predicated on the caller’s bias. But the point is the Phisix (at center window) has missed the “gravy train”! Or…so it seems?

But compared to the past rallies which manifested of sharp V-shaped bounces, this time we are seeing some signs of consolidation (circle).

A prolonged consolidation or a gradual ascent should exhibit the recovery’s resilience, but again bottoming as a function of an evolving process within a cycle will mean repeated tests where investor patience and grit amidst prevailing fear should eventually be rewarded.

Yes, we were delighted to see that even as the US markets lost meaningful grounds last Wednesday (by about 2%), the Phisix “diverged” by recording moderate gains Thursday.

We have noted in the past that for the Phisix to reestablish strong indications of a recovery, (see Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom) durability in the form of less sensitivity to external variables should be seen as a guide, aside from progressive technical action, of which both signs seems to have been manifested this week.

Monday should be another test day since the US markets ended the week with moderate losses. Since Mondays are traditionally the weakest day of the week, the Phisix could be subject to some selling pressure following the weakness in the US markets. But for as long as the Phisix keeps the pace of its losses to within the range of losses in the US markets, we should remain in a consolidation phase with a recovery bias.

Dead Calm Waters Reveals Attribution Bias

One must be reminded that betting on future outcomes requires the understanding of risk and reward tradeoffs.

When we talk of a “bottom” we don’t even go near to the suggestion of a mystical formula or some alternative forms of voodoo rituality applied to the financial sphere but one where we distinguish the odds of the probability of incurring more losses against that of the odds of the prospective gains. In simple words, the bet of a bottom means the understanding that the room for further loss is significantly less than for future gains. But this, in contrast to the expectations of market punters, happens OVERTIME and requires PATIENCE.

I might like to add that the negative sentiment have truly reached extremes seen in the ground levels. In a recent social function which I regularly attend, where early this year participants seem agog over the market despite the decline (the assumption is that the market’s decline was short and shallow), today almost everyone seem to shun the topic of the stock market, which for me appears to uncannily resemble the investing atmosphere in 2002, a great window for grabbing outsized returns.

Nonetheless, I gathered that losses for some have been staggering enough to dismiss the existence of the stock market. And some have even fostered acerbity towards the financial intermediary agents (bankers, stock brokers and analysts).

Of course I might be accused of reading the sentiment of a group into the whole (fallacy of composition) but as we previously pointed out market internals, as seen by declining daily trades, have depicted the same picture where speculative froth engaged by mostly retail market participants have substantially ebbed. Since speculators have been caught in long positions due to their inability to accept losses or have been immobilized, trading activities have been restrained.

The lesson here is one of the Attribution Bias, where people tend to take credit on successful endeavors to inherent skills but deny responsibility for failures by imputing situational variables either by “randomness” or by the influences of others to their decision making.

Thus, when the market is buoyant everyone seems to know of the “whys” and the “whats” and the “who-drives-what” in the marketplace, and conversely when the market is dreary, the atmosphere seems like dead calm waters.

Negative Real Interest Rates and Emerging Market Bubbles

4. Negative Real Interest Rates.

Mainstream analysts or experts impute stock market investing to micro or macro events, some deal with the technical aspects. As a contrarian, we see the market as mainly the alternative function of money: a medium of exchange, a unit of account (means for economic calculation) and a store of value.

Not everything can be explained by micro or macro factors. Yet mainstream analysis insists on such lockstep correlation. We beg to differ.

Policies administered by government/s have manifested significant impact to asset prices. That is the reason for the phenomenon of bubbles. Investor irrationality is only an aggravating circumstance to a bubble in formation, because this cannot thrive without the principle of leverage (margin trades or credit expansion).

Following years of monetary accommodation and extensive growth of credit intermediaries of all sorts-derivatives to margin trades to alphabet soup of securitization, the implosion of the housing bubble in the US and other Anglo Saxon Economies has left central banks apprehensive of the negative economic growth impact from declining asset prices. As such, monetary authorities have mostly left policy rates lower than instituted “inflation” benchmarks hence negative real rates. Aside, they have been conducting massive liquidity bridging operations and applying fiscal subsidies in support of consumers suffering from the string of recent losses. We have explained most of these in Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

In addition, monetary pegs and mercantilist trading structures of key emerging markets have apparently resulted to a globalized mechanism for transmission of inflationary activities whose effects are now ostensibly rechanneled from Wall Street securities into commodities and emerging markets.

This insightful excerpt from Prudent Bear’s Doug Noland in his Credit Bubble Bulletin (highlights mine),

``prevailing inflationary pressures are global in nature. Wall Street finance is the source fueling the boom, and it’s running outside the Fed’s control. American asset inflation and resulting wealth effects are minimal, while price effects for food, energy, and commodities are extreme. In contrast to previous inflationary booms, while some selected groups benefit, the vast majority of people today recognize they are being hurt by rising prices. This hurt comes concurrently with atypical housing price declines. Today’s price effects pummel already weakened consumer sentiment, as opposed to previous effects that tended (through asset inflation) to bolster confidence. Furthermore, current inflationary forces are destabilizing and even destructive to many businesses, while playing havoc with the fiscal standing of federal, state and municipal governments.

``Revolving around booming Wall Street finance, previous inflationary booms naturally fueled surges in securities issuance and speculation. These Bubble Effects worked as powerful magnets in attracting foreign financial institutions, foreign-sourced speculators, and cheap foreign-sourced borrowings (i.e. yen borrowings financing higher-yielding U.S. securities) that all worked in concert to “recycle” our Current Account Deficits (“Bubble dollars”) directly back to our securities markets.

``In contrast, today inflationary forces largely bypass U.S. securities to play global energy, commodities, and hard assets. Foreign financial institutions are fleeing the U.S. risk intermediation business, while “Bubble dollars” are chiefly recycled back into Treasury and agency securities (where they now have minimal effect on U.S. home and asset prices). Meanwhile, the massive global pool of speculative finance is today focused on energy, commodities and the “emerging” economies.”

In short, what you are witnessing today is an ongoing massive shift in the inflation bias or bubble progression on a global scale from securities to commodities and to emerging economies.

Figure 2: stockcharts.com: Soaring Commodities and Latam Bourses!

Look at today’s commodity and commodity affiliated markets (see figure 2): Oil at an ALL time high $126 per barrel! The CRB Index is also at a Fresh record high! And commodity heavy benchmark of Latin American bourses (Dow Jones Latin America) also on record!

A world of negative real rates is likely to buttress such powerful dynamic. What you will likely have is a phenomenon of funds chasing winners which should spillover to a broader spectrum of commodity associated assets (yes we are seeing signs of the emergence of Ponzi financing in commodities), hence the bandwagon effect in motion!

While the impact of such inflation bias will always be unequally distributed between producers, sellers and buyers of commodities as discussed in my previous blog, Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline, the Philippine economy as an erstwhile major commodity exporter is a strong contender to be a beneficiary from the globalized inflation machinery.

Figure 3: PSE subindices: Recent Recovery Primarily Driven By the Mining Sector

Incipient signs of such rotation have already surfaced.

While the Phisix remain depressed down 23.25% year to date as of Friday’s close, the mining index (equally down 16.5%. y-t-d) has seemingly bottomed since March and has gradually been in consolidation and now seen moving higher-see figure 3 (Japanese Candlestick). This comes after a 6% jump this week, mostly from Atlas Consolidated which has soared by 25%! You don’t normally see a 25% run over a week from an index heavyweight (second largest weighting in the mining index at 16% after Philex) especially in a BEAR market! This only strengthens our case that the Phisix will likely recover soon.

And given that both the above technical picture plus the developments in the world market strengthened by a negative real rate environment, it is likely that the mining and oil sector will lead the Phisix’s recovery over the coming sessions.

All other indices in the chart are underwater on a year-to-date basis, this includes Banking (blue) down 19.75%, Commercial Industrial (violet) 20.59%, Property (red) 29.95%, Holding (green) 27.62% and Services (orange) 19.82%.

Moreover, investors will always find justification for an investment theme. Economic growth supported by capital investments over a dominant asset class is likely to become a feedback loop in a self reinforcing bubble cycle.

Figure 4 GMO: “They have the growth. We don’t. What’s to discuss?”

As the sagacious fund manager Jeremy Grantham of GMO (Jeremy Grantham, Richard Mayo and Eyk Van Otterloo) recently argued in his outlook, historically bubbles would need a strong underlying fundamental case from which the bubble is anchors upon.

In terms of emerging markets as shown in Figure 4 it is likely to be found in the consistent outperformance of economic growth. In the poignant words of Mr. Grantham, ``They have the growth. We don’t. What’s to discuss?”

Like us, Mr. Grantham believes that the next bubble will be on emerging markets. Quoting at length Mr. Grantham (all highlights mine),

``For one, emerging will increasingly be seen on a country-by-country basis. Nevertheless, the second wave of let’s-look-like-Yale money from state plans is still in its early stages and looking to invest overwhelmingly in emerging market funds, not in the specific country funds of the Yales and Princetons.

``For another caveat, the GDP growth rate of a country does not in the very long term necessarily determine how much money a country’s stock market will make. Long-term market return may depend more on profit margins. But investors believe GDP growth really matters, and Japan went to 65x earnings despite average or lower corporate profit margins.

``But the third caveat is the most serious; this emerging bubble can easily be postponed or even stopped before it really begins by the current financial problems and the slowing growth rates of the developed world that are likely to follow.

``My own view is that our credit problems will impact and interrupt the recently sustained outperformance of emerging in the intermediate term, say, the next 3 years, even as the acceptance of this emerging bubble case grows. Such interruptions may be quite violent but, despite them, at the next low point for the U.S. market the emerging markets are quite likely to do no worse and in the recovery they will go to a very large premium. And if, just if, the U.S. gets very lucky indeed and muddles through without serious market and economic problems, then the emerging bubble will of course occur more quickly and smoothly.”

Phisix: Political and External Risk Variables

So yes, allied with the views of Mr. Grantham as we have previously mentioned, the Phisix is envisaged by two major risk factors; one is domestic political risk and the other is the transmission factors of the external risk environment.

Political risk could be associated with the risk of destabilizing markets through populist policies such as overextending subsidies to reverse the gains or improvements of the country’s fiscal position and balance sheet, combined with threats to the sanctity of private property ownership via “nationalization” or management “take over”.

So when we read of canards repeatedly circulating in the emails of “why the Philippines is poor?” we understand that it is the fundamental aspect of principally NOT having ENOUGH capital investments in the country and NOT because of lack of “moral” leadership why the Philippines is “poor” (yea ironically the Philippines is “poor” but home to 3 of the 10 world’s largest malls and growing!).

It is because of the lack of appreciation of the markets through property ownership and the enforcement of contracts, the lack of savings, a dearth of platform or infrastructure for establishing pricing efficiency, the lack of competitive environment, a politically dependent society or culture and importantly the high costs of political intervention and bureaucracy.

Remember the popular personality based politics theme of corruption represents a symptom and NOT the disease. Corruption basically is an offshoot to suffocating network of bloated bureaucracy as a result of overregulation and inordinately high taxation due to huge liabilities accrued from failed policies and deep dependence on political gratuity (a.k.a. pork barrel).

Economics 101 tells us that the more you want of something you LOWER the costs, in contrast, the less you want of something you INCREASE the cost. If you want to lessen the incidences of corruption you increase the cost of committing corruption. If corruption is an offshoot to overregulation then streamlining of laws, reduced bureaucracy and lower taxation should be encouraged aside from strictly enforcing laws.

In addition it is NOT governments that drive the wealth of economies or responsible for the upgrading of the standard of living of societies, otherwise communism (Stalin’s USSR, Mao’s China, Kim’s North Korea, Castro’s Cuba) would have succeeded; it is the people!

If governments empower its people to conduct trade openly with LESS political intervention thereby strengthening the division of labor within its economy then it reduces the country’s risk premium, lowers the hurdle rate, reduces the cost of doing business and thus becomes competitively attractive for capital investments.

Governance permissive of a market economy or an entrepreneurship culture and less dependence on the political leadership is the common denominator of successful economies. Because it is a governing policy to limit government’s intervention then the issue of “moral” becomes moot.

But when you see the leadership use its coercive power of its legally clothed leviathan to conduct political harassment or render vindictive actuations on presumed political opponents in the name of public services then it raises questions among potential investors about the sacredness of equity ownership.

This in itself increases the cost or barriers of doing business. Hence capital would seek a hefty premium in terms of higher rate of return or yields for it to consider deploying them into the country. The higher the costs the lower rate of investments.

These incessant political interventions is the reason why the Philippines will remain politically and economically disadvantaged and will thus depend on the global or regional cycle for its upliftment than from intrinsic factors such as the popularly demanded (but largely ineffective) “government driven” initiatives instead of the unpopular market oriented reforms. To quote Ludwig von Mises, ``The effect of its interference is that people are prevented from using their knowledge and abilities, their labor and their material means of production in the way in which they would earn the highest returns and satisfy their needs as much as possible. Such interference makes people poorer and less satisfied.”

As for external risk variables, the country is faced with the same macro risks as the others, a sharp US recession, a steep global economic slowdown, accelerating inflationary policies which could fuel the intensity of the present bubbles and or goods and services inflation, geopolitical risks of public upheavals (triggered by food crisis) or potential military conflicts (over resources), a US dollar crash, global depression and other fat tails.