Political Paralysis Paves Way to Bubble Bust Conditions

If politics continue to shackle central bankers, then the risks of a slowdown transitioning to a recession will get magnified.

The lucid example of political deadlock hounding the markets from the EU seems best captured by this Telegraph report[1]

The head of the European Central Bank hit out at the political paralysis gripping the region as he warned the eurozone's set-up was "unsustainable"

Mario Draghi said the central bank could not "fill the vacuum" left by member states' lack of action as it was claimed the zone is on the point of "disintegration".

Amid escalating talk of a potential bail-out for Spain, the president of the ECB said the central bank was powerless to stop the debt tornado. "It's not our duty, it's not in our mandate" to "fill the vacuum left by the lack of action by national governments on the fiscal front," he said.

Over at the worsening economic conditions in China, political debates over policy have once again been best illustrated by this comment from a former central banker turned representative for a think tank[2]

Americans and Europeans like it. Investors like it because they want to speculate on stocks. The whole world is hoping China will relax policy," Xia told Reuters.

"We will fall into a trap if we do. We will not be that stupid," Xia said, adding that the government should only stimulate economic growth in a "balanced and modest" way, while forging ahead with structural reforms to sustain growth over the longer term. China stimulus unnecessary, risks long-term damage

As a reminder, the current issue here has NOT been about a supposed “squeeze” on government spending and the supposed effects of low levels of capital from it.

The bank runs in the PIGS dismisses this false and self-contradictory logic, Spain experienced 100 billion capital flight during the first 3 months[3], as bank runs have been symptomatic of the fear of devaluations on the heightened prospects of a severance of EU ties.

The monumental capital flight has produced negative interest rates on the treasury yields of Switzerland[4] (see above) and also in Denmark.

Instead, the issue here has been the unwinding of MASSIVE malinvestments from EXCESSIVE government spending (welfare, bureaucracy, bailouts, and etc…) that has not only produced unsustainable loads of debt, but also resulted to the CROWDING out of the private sector investments. When government confiscates scarce private sector resources through taxation and spends it, the private sector losses ‘capital’ and opportunity from which to undertake productive activities. This is known as OPPORTUNITY costs; something which becomes a monumental blackhole to mainstream logic, whose ideas are premised on the laws of abundance.

Of course, add to this the misdirected resources from private the sector, particularly the real estate industry, whom had been induced by bubble ‘convergent interest rate’ policies.

The capital flight from crisis affected Euro nations has also been affecting the US where volatile money flows could exacerbate the current boom-bust dynamics. Add to this policy actions to address on such flows[5].

Yet the predicament of crisis afflicted EU nations has essentially been about vastly diminished competitiveness from asphyxiating bureaucracy and choking regulations, particularly in the labor markets[6].

Accounts of massive tax avoidance from current tax increases only debunk the supposed solution of increased government spending. Greeks have shown that they have not been amenable to paying NEWLY IMPOSED taxes[7].

If people truly believed that government spending is the solution then they would have volunteered payment for taxes. In reality, both the intensifying tax avoidance and capital flight defeats the silly statist illusory elixirs.

Even China today has been revealing signs of emergent bank runs[8] and such bank run seems to coincide with the recent depreciation of the yuan relative to the US dollar. This increases signs of uncertainty over China’s bubble economy.

Yet in general, current uncertainty has been aggravated by the political paralysis which has led central bankers to dither from pursuing further inflationist policies.

This Reuters article entitled “Central Banks to hold fire... for now[9]” nails it.

The intensifying euro zone crisis and uncertain global growth outlook have raised hopes for a policy response from major central banks but, while it could be a close call, they are likely to resist pressure to act in the coming week.

When central banks and the banking system stops or withholds from further inflating, the ensuing market reaction from a PREVIOUS inflationary Boom would be a Bubble Bust.

As the great dean of Austrian school of economics explained[10]

For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.

The bank contraction reverses the economic picture; contraction and bust follow boom. The banks pull in their horns, and businesses suffer as the pressure mounts for debt repayment and contraction…

This, then, is the meaning of the depression phase of the business cycle. Note that it is a phase that comes out of, and inevitably comes out of, the preceding expansionary boom. It is the preceding inflation that makes the depression phase necessary.

Pieces of the jigsaw puzzles have been falling right in place into the boom bust picture.

And another thing, if there should be a global recession it is not certain that this will be deflationary, as this will depend on how central bankers react. The term deflation has been adulterated by deliberate semantical misrepresentations.

Not all recessions imply a monetary deflationary environment as alleged by a popular analyst. The US S&P 500 fell into TWO bear markets 1968-70 and 1974-1975 even as consumer price inflation soared (blue trend line).

If in case the same phenomenon should occur where stagflation becomes the dominant economic landscape, then a bear market in stocks will likely coincide with a bull market in commodities.

Yet for now everything remains highly fluid with everything dependent on the prospective actions by policymakers

As of this writing, reports say that the EU has been preparing for the $620 ESM Rescue fund for July[11]. If this is true then perhaps, this means the ECB will begin her next phase of massive monetization of debt.

Let me reiterate my opening statement of last week[12]

Like it or not, UNLESS there will be monumental moves from central bankers of major economies in the coming days, the global financial markets including the local Phisix will LIKELY endure more period of intense volatility on both directions but with a downside bias.

I am NOT saying that we are on an inflection phase in transit towards a bear market. Evidences have yet to establish such conditions, although I am NOT DISCOUNTING such eventuality given the current flow of developments.

What I am simply saying is that for as long as UNCERTAINTIES OVER MONETARY POLICIES AND POLITICAL ENVIRONMENTS PREVAIL, global equity markets will be sensitive to dramatic volatilities from an increasingly short term “RISK ON-RISK OFF” environment.

And where the RISK ON environment has been structurally reliant on central banking STEROIDS, ambiguities in political and monetary policy directions tilts the balance towards a RISK OFF environment.

---

[1] Armistead Louise Eurozone is 'unsustainable' warns Mario Draghi, Telegraph.co.uk, May 31, 2012

[2] See HOT: China’s Manufacturing Activity Falls Sharply in May June 1, 2012

[3] CNBC.com Spain Reveals 100 Billion Euro Capital Flight, June 1, 2012

[4] Bloomberg.com Switzerland Govt Bonds 2 Year Note Generic Bid Yield

[5] See The Coming Colossal Bernanke Bubble Bust May 30, 2012

[6] See Germany’s Competitive Advantage over Spain: Freer Labor Markets, May 25, 2012

[7] See Is Greece Falling into a Failed State? May 28, 2012

[8] See Is China Suffering from Bank Runs too? June 2, 2012

[9] Reuters.com Central Banks to hold fire... for now, June 2, 2012

[10] Rothbard Murray N. Economic Depressions: Their Cause and Cure, Mises.org

[11] See HOT: EU Readies $620 ESM Rescue Fund for July, June 3, 2012

[12] See The RISK OFF Environment Has NOT Abated, May 27, 2012

The Myth of the Middle Income Trap

The Economist writes,

The forces of economic convergence are powerful, but not all powerful. Poor countries tend to grow faster than rich ones, largely because imitation is easier than invention. But that does not mean that every poor country of five decades ago has caught up, as today’s chart shows. It plots each country’s income per person (adjusted for purchasing power) relative to that of America, both in 1960 and in 2008. The chart appeared in the World Bank's recent China 2030 report. If every country had caught up, they would all be found in the top row. In fact, most countries that were middle income in 1960 remained so in 2008 (see the middle cell of the chart). Only 13 countries escaped this middle-income trap, becoming high-income economies in 2008 (top-middle). One of these success stories, it should not be forgotten, was Greece.

This is an example of how macro statistics can be used to mislead people. Countries essentially don’t fall into “traps”, it is the individual who make or unmake their respective wealth.

What truly restrains people from advancing is when productive resources are diverted into non-productive use. That’s basic, and is a matter of the law of opportunity costs or the law of scarcity.

And what induces non-productive use of resources are insatiable government spending, the welfare state, bloated bureaucracy and trade restrictions, anti-competition laws, bubble policies (or policies which induces consumption), inflationism (QEs) and all sorts of market distorting interventionism. Yes, all of them are interconnected.

As the great Professor Ludwig von Mises wrote, (bold emphasis added)

Each authoritarian interference with business diverts production, of course, from the lines it would take if it were only directed by the demand of the consumers as manifested on the market. The characteristic mark of restrictive interference with production is that the diversion of production is not merely an unavoidable and unintentional secondary effect, but precisely what the authority wants to bring about. Like any other act of intervention, such restrictive measures affect consumption also. But this again, in the case of the restrictive measures we are dealing with in this chapter, is not the primary end the authority aims at. The government wants to interfere with production. The fact that its measure influences the ways of consumption also is, from its point of view, either altogether contrary to its intentions or at least an unwelcome consequence with which it puts up because it is unavoidable and is considered as a minor evil when compared with the consequences of nonintervention.

Restriction of production means that the government either forbids or makes more difficult or more expensive the production, transportation, or distribution of definite articles, or the application of definite modes of production, transportation, or distribution. The authority thus eliminates some of the means available for the satisfaction of human wants. 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.

In short, the more intervention, the lesser the capital accumulation or reduced economic growth. When politicians become greedy enough to divert much wealth into policy driven consumption activities then productivity diminishes. And that's where the so-called statistical 'trap' comes in.

Bottomline: the so-called Middle income trap represents a macroeconomic hooey.

Are Renewable Energy ‘Renewable’?

One of the most valuable lessons I have learned in life is not to see things as presented or as they are. That’s because things or events that we see or sense does not cover on how they existed or how they got there in the first place.

I am indebted to the late great proto-Austrian Frederic Bastiat, who inspired an overhaul of life’s outlook personified by this stirring passage

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause - it is seen. The others unfold in succession - they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.

This applies to everything we do.

And these have been most pronounced especially in the domain of politics where populist political solutions are sold on the merits of superficiality or visibility.

In the realm of environmental politics, one good example would be the politically correct populist practice of ‘Earth Hour’.

We are told to close lights for an hour so that we can symbolically celebrate on ‘saving the environment’ by reducing carbon footprints.

However in reality, unless we decide to stop living, we will be using energy. PERIOD.

And the alternative to using ‘environmental hazardous’ conventional fossil based energy would be to revert to the medieval age and use candles. People hardly see that candles signify as more environmental unfriendly than the conventional energy.

Of course by proposing to cut lights also extrapolates to stopping or to reducing production and trade. Doing so means creating shortages in people’s needs. This means widespread hunger and famine. This brings the Malthusian nightmare to a reality.

How do you suppose that we would be able to survive 6.77 billion people by reverting to the medieval age of economic system?

So saving the environment means we end up killing one another (politics of plunder-via war) or killing ourselves (man made catastrophe).

It isn’t that Malthus was right. Instead, it is because political correctness founded the concept of saving earth signifies as concealed misanthropy.

The same blight haunts proponents of renewable energy.

From the surface, renewable energy would seem as environmental friendly. That is what is seen. What is not seen is how environmental damaging renewable energy would be when they are constructed for commercial operations.

Matt Ridley eloquently explains, (bold emphasis added)

It turns out that the great majority of this energy, 10.2% out of the 13.8% share, comes from biomass, mainly wood (often transformed into charcoal) and dung. Most of the rest is hydro; less than 0.5% of the world's energy comes from wind, tide, wave, solar and geothermal put together. Wood and dung are indeed renewable, in the sense that they reappear as fast as you use them. Or do they? It depends on how fast you use them.

One of the greatest threats to rain forests is the cutting of wood for fuel by impoverished people. Haiti meets about 60% of its energy needs with charcoal produced from forests. Even bakeries, laundries, sugar refineries and rum distilleries run on the stuff. Full marks to renewable Haiti, the harbinger of a sustainable future! Or maybe not: Haiti has felled 98% of its tree cover and counting; it's an ecological disaster compared with its fossil-fuel burning neighbor, the Dominican Republic, whose forest cover is 41% and stable. Haitians are now burning tree roots to make charcoal.

You can likewise question the green and clean credentials of other renewables. The wind may never stop blowing, but the wind industry depends on steel, concrete and rare-earth metals (for the turbine magnets), none of which are renewable. Wind generates 0.2% of the world's energy at present. Assuming that energy needs double in coming decades, we would have to build 100 times as many wind farms as we have today just to get to a paltry 10% from wind. We'd run out of non-renewable places to put them.

You may think I'm splitting hairs. Iron ore for making steel is unlikely to run out any time soon. True, but you can say the same about fossil fuels. The hydrocarbons in the earth's crust amount to more than 500,000 exajoules of energy. (This includes methane clathrates—gas on the ocean floor in solid, ice-like form—which may or may not be accessible as fuel someday.) The whole planet uses about 500 exajoules a year, so there may be a millennium's worth of hydrocarbons left at current rates.

Read the rest here.

What you see isn’t always what you get.

Should Your Housemaid Invest In The Stock Market?

``Demanding immediate success invariable leads to playing the fads or fashions currently performing well rather than investing on a solid basis. A course of investment, once charted, should be given time to work. Patience is a crucial but rare investment commodity. The problem is not as simple as it may appear; studies have shown that businessmen and other investors abhor uncertainty. To most people in the market place, quick input-output matching is an expected condition of successful investing.” David Dreman, Contrarian Investment Strategies: The Next Generation

Should your housemaid invest in the stock market?

All Actions Are A Function Of Tradeoffs

Recently, I chance upon a message advocating housemaids to invest their money in the stock market. The supposed goal is to help the underprivileged financially by capitalizing on the rising markets.

While I would agree with the underlying motive, the basic problem with this idea is that purported intentions hardly square with reality.

In the real world, all actions have consequences. And actions are driven by the preferences (value scale) and incentives of individuals to seek relief from discomfort.

In short, people’s actions represent purposeful behaviour.

As the great Ludwig von Mises explains[1], (all bold highlights mine)

``Acting man is eager to substitute a more satisfactory state of affairs for a less satisfactory. His mind imagines conditions which suit him better, and his action aims at bringing about this desired state. The incentive that impels a man to act is always some uneasiness. A man perfectly content with the state of his affairs would have no incentive to change things. He would have neither wishes nor desires; he would be perfectly happy. He would not act; he would simply live free from care.”

``But to make a man act, uneasiness and the image of a more satisfactory state alone are not sufficient. A third condition is required: the expectation that purposeful behavior has the power to remove or at least to alleviate the felt uneasiness. In the absence of this condition no action is feasible. Man must yield to the inevitable. He must submit to destiny.”

This means that the consequences of everyone’s action for betterment can have short term or long term effects. Hence, in a world of scarcity, everyone’s action is a consequence of a tradeoff in personal values and preferences.

And one cannot isolate actions taken by individuals from these underlying influences, even from the perspective of impulses.

Again from von Mises[2],

``He who acts under an emotional impulse also acts. What distinguishes an emotional action from other actions is the valuation of input and output. Emotions disarrange valuations. Inflamed with passion, man sees the goal as more desirable and the price he has to pay for it as less burdensome than he would in cool deliberation. Men have never doubted that even in the state of emotion means and ends are pondered and that it is possible to influence the outcome of this deliberation by rendering more costly the yielding to the passionate impulse.”

Take for instance in the recent infamous hostage taking[3] (at the Luneta Grandstand in the Philippines), which has now become a political controversy.

Some have suggested that the actions of the criminal signified that of a fit of rage. True, but again it was choice made from a tradeoff of what the culprit sees as a better way to resolve a personal unease or predicament.

In other words, a choice had been made based on short term time horizon (immediate gratification) which alternatively meant the failure of the felon’s emotional intelligence which paved way for a severe miscalculation that proved to be fatal for him, the victims and politically strained the relations diplomatic between the nationalities involved in the unfortunate incident.

Also there is a suggestion that the perceived depravity of the due process which prompted for the criminal’s misdeeds should be detached. False. Again people are driven by purposeful behaviour where actions and motives are inseparable, interrelated or intertwined, again from the Professor Mises[4], “It is impossible for the human mind to conceive a mode of action whose categories would differ from the categories which determine our own actions”

The point of the above is to show you that people’s choices are ALWAYS based on tradeoffs, all of which comes with intertemporal (occurring across time) consequences, positive or negative, where good intentions can lead to the opposite of the desired goals.

Housemaids And The Bubble Cycle

And how does this apply to the wisdom of housemaids investing in the markets?

The fundamental reason for such advocacy is predicated on the broadening expectation of the linearity of the ongoing trend (see figure 1).

Figure 1: Bloomberg: The ASEAN Bull Market

As earlier explained[5], the ASEAN bullmarket appears to be segueing into what billionaire George Soros calls as the “growing conviction” phase of the boom cycle.

This simply means that as the uptrend becomes more entrenched, people will intuitively flock to where the returns are. In behavioural finance this is called the herding effect or the Herd Behavior.

Indonesia (JCI, green) is the first among the contemporaries to surpass the 2007 highs. All the rest, particularly Philippines, (PCOMP yellow), Malaysia (KLSI, orange) and Thailand (SET, red) appear to be at the threshold of testing their 2007 highs.

The point of my showing the synchronous action of ASEAN markets is to demonstrate that this hasn’t been mainly because of national political-economic issues, but because of other variables UNSEEN by the public or by even most of the experts. Yet among the popular experts, who at the start of the year, predicted that the Phisix will likely break 3,800?

Here is what I wrote in May 2009[6],

``Nonetheless, if the Phisix does end the year above 2,500, we may expect a full recovery (Phisix 3,800) by the end of 2010 or even an attempt at the 5,000.”

5,000 may seem too optimistic but one can’t discount the acceleration of the speed and depth of the shaping bullmarket. Sri Lanka and Bangladesh for instance on a year to date basis is up astoundingly by 73% and 49% respectively, compared to the Phisix at 22%[7] which makes ASEAN bourses look dismal. At any rate, my predictions are mostly becoming a reality.

And where money is seen as being picked up on the streets, even housemaids will, by their volition, perhaps prodded or influenced by their peers or their household employers, will gravitate to “easy money”.

Remember the stock market is a social phenomenon driven by expectations, whether these expectations are valid or not[8].

And the rising tide compels people to make various attributions to market actions, such as economic growth or earnings or mergers and acquisitions, no matter how loosely correlated they are or how little relevance they are with the genuine market drivers. Most of this account for as popular dogmatic fables or widely held superstitions as evidences does not support the causality nexus from such premises.

What has been driving today’s stock markets has been the tsunami of liquidity, or what I have long called as the Machlup-Livermore[9] paradigm, from the coordinated monetary policies by global central banks in an attempt to forestall the “deflation” bogeyman.

And these policies have had relative effects on the marketplace, where areas largely unblemished from the recent bubble implosion appear to have been “positively” influenced. This seems quite evident in the markets of the periphery more than that of the developed economies, from which most of these policies have been directed.

I say positive, in the context, where rising markets are being misconstrued as signs of rising prosperity, which is illusory, when in fact what such dynamic account for is the tacit depreciation of the currency, but presently seen in the dynamic of “asset price inflation”. As we have long said, these are symptoms of the seductive sweet-spot phase of inflation. Heck, why has gold been rising against ALL currencies[10], if this hasn’t been so?

Eventually this illusion morphs into nasty bubbles (see figure2), or at worst, inflation spiralling out of control.

Figure 2: World Bank: Paper Money and Banking Crisis

And it is NO coincidence that since the world went off the quasi gold standard of the Bretton Woods system in 1971 the account of banking crisis globally have exploded.

Why?

Because inflation, as a short term fix is like narcotics, is addicting.

Again Professor Mises[11],

``The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.

In short, the paper money-fractional reserve central banking system induces boom bust cycles only shifts around the world. And ASEAN economies, as well as other peripheral emerging economies, seem like candidates to a formative bubble.

And this is why we also have long been saying of a Phisix 10,000[12] or the potential of the Philippine Phisix to reach bubble proportions sometime in the future.

If experts hardly grasp the dynamic of bubble cycles, how the heck do you expect housemaids to understand?

The Housemaid Indicator

Housemaids investing in the stock markets have NOT been unusual. During the acme of the bubble cycle in China in 2008, the onrush of retail punters into stocks, which included housemaids, signified the peak of frenzied activities.

As Shujie Yao Dan Luo of The University of Nottingham wrote in their recent study[13], (emphasis added)

``Most of these investors, which included farmers, cleaners, taxi drivers and house maids, knew little about stock markets and how share prices were determined. Many of these people started investing in the stock markets when prices had already risen rapidly to peak levels, just before the market bubble burst. The participation of these ‘envious’ investors artificially prolonged the bullish market and created a much larger market bubble than would have occurred had they not become involved.”

In short, retail investors GOT SINGED and were left HOLDING THE EMPTY BAG. They accounted for as the FOOL in the Greater Fool Theory.

Former Morgan Stanley analyst Andy Xie describes the “Maid Indicator” as great way of looking at market tops, he says[14],

``Now housemaids are in the market. Who else? Never underestimate 1.3 billion people. In China, they say you should take the shoeshine boy’s advice. Many would listen to him. Welcome to China, the land of getting rich quick.”

In other words, retail money represents unintelligent money. Retail money is mostly drawn into the prospects of free lunches and who turn stock markets into casino-like gambling orgies. They signify as the culmination of irrational behaviour.

A most recent example has been in the US markets, where there has been a pronounced shift of retail investors OUT of stocks and INTO bonds.

And guess what? It would appear that the counterpart of the Maid Indicator or the RETAIL money indicator is accurate (figure 3).

Figure 3: Retail Investors Hardly Gets Investing Right

As the New York Times highlighted on this monumental shift, markets immediately sprung to the opposite direction against the bets of retail money.

As I recently wrote[15], ``I’d suggest that, like always, they are wrong and betting against them (in stocks) would likely be a profitable exercise.”

By the way things are developing, I could be validated anew.

And like my son’s finance professor who initially required that he and his classmates to invest in the stock markets for the semester (four months), to which I argued against, and instead told my son that his professor speak to me, it must be understood that profiting from stock markets is NOT a function of three or four months exposure unless one is positioned as a PUNTER than an investor.

Stock Market investing, like all other successful endeavours requires diligence, perseverance, perceptiveness and patience. And importantly, unlike other professions, it also requires the ability to think independently and to resist social or peer pressures, which alternatively means going against the crowd or popular wisdom even to the risk of ostracism.

For instance the world’s most successful stock market investor Mr. Warren Buffett, at the height of the dot.com boom was labelled a “dinosaur” for avoiding investments in technology companies. In hindsight, he was vindicated. His advice[16], “If you’re applauded, worry. Great moves are usually greeted by yawns.”

The same holds true with the fallacious notion of learning from simulated stock market games. When one deals with “monopoly” play money, the tendency is to GET aggressive because there is no real cost. To lose is simply a game. Yet repeated exposure to simulated games could amplify risk tolerance and aggressiveness at the expense of profit opportunities.

In other words, simulated trading games impart the wrong traits or attitudes in dealing with the financial markets. Since the market is a function of social actions, the understanding of people’s behaviour and the direction of such actions is a MUST.

Yet one must be reminded that since everyone has different value scales and preferences, these can’t be quantified or seen in aggregates, which has been the major flaw of mainstream economics.

Investing Is NO Free Lunch

Let me be clear with my position, I am not opposed to ANYONE, including maids, from engaging the markets. What I am vehemently opposed with is the idea of free lunches as path to prosperity.

Anyone who engages in the markets must be capable to deal with the intertemporal tradeoffs between risks and rewards.

Because every action has a consequence, the inability to reckon with such tradeoffs could translate into future losses far greater than any interim gains.

Another thing which I am rabidly opposed with is the pretentious morality of uplifting the underprivileged by advocating unnecessary exposure on the stock markets when the participants are under qualified to comprehend or imbue on the attendant risks involved.

To expose people to future losses which could be far greater than the current gains defeats the goal of social advancement.

Just ask the horde of speculators of the US housing bubble who had been apparent “victims” of Federal Reserve and US government policies. They who profited at first have now been suffering from the losses out of excessive speculations. These gullible participants were lured and abetted by the immoral policies of turning stones into bread.

Yet failed policies do NOT exonerate the individual’s recklessness because many have seen the potential impact of bubble policies prior to the bust per se. Warnings were unheeded because of the enticements of social pressure and the seeming perpetuation of rising prices.

And such consequentialist notion where “the ends justify the means” or the consequences of actions serving as moral propriety also fails to account for the tradeoff between present and future ramifications from such actions. Teaching housemaids to engage in risky ventures without the necessary understanding of risks is tantamount to gambling.

Another way to say it is that the reorientation of people’s behaviour towards reckless undertakings which is likely to result to adverse consequences is not morally justifiable nor is gambling, in anyway, going to create financial upliftment.

If the retail under qualified entities (housemaids, drivers or low skilled workers) insists on investing in the financial markets, then the right approach would be to let experts handle their money via mutual funds or UITF (Unit Investment Trust Funds) or through pooled discretionary accounts with able and qualified fund managers.

Yet, even if the experts do manage their accounts, the communication of the tradeoffs between risks and rewards should be a prerequisite or a sine qua non for the simple reason of harmonizing the expectations of the client and managers.

Unmatched expectations are often the root of most conflicts. In the financial markets, expectations in time preferences could be a principal source friction for a principal-agent relationship.

Thus, we go back to the simple operating precept: investing is NO Free lunch, period. That has to be understood by both retail investors (housemaids) and fund managers. Anybody who says otherwise is either being untruthful or deceiving oneself or the other party.

Beware of false prophets.

---

[1] Mises, Ludwig von The Prerequisites of Human Action, Human Action Chapter 1 Section 2

[2] Ibid

[3] See The Bloodbath At Rizal Park Hostage Drama Demonstrates The Pathology of Government, August 24, 2010

[4] Mises, Ludwig von The Alter Ego Human Action Chapter 1 Section 6

[5] See How To Go About The Different Phases of The Bullmarket Cycle, August 23, 2010

[6] See Kentucky Derby And The Global Stock Market, May 10 2009

[7] See Global Stock Markets Update: Peripheral Markets Take Center Stage, September 4, 2009

[8] See A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino, January 9, 2009

[9] See Are Stock Market Prices Driven By Earnings or Inflation?, January 25, 2009

[10] Gold.org, Daily gold price in a range of currencies since January 2000

[11] Mises Ludwig von, The Market Economy as Affected by the Recurrence of the Trade Cycle, Chapter 20 Section 9

[12] See Phisix 10,000:Clues From Philippine Bond Offering, July 15, 2009.

This has been a long held prediction of mine even prior to the last bubble cycle. The 2007-2008 bearmarket I had interpreted as a countercyclical trend in a secular uptrend. The current underlying secular trend reverses once the bubble dynamic, cultivated domestically, implodes. This has NOT been the case in the 2007-2008, which was largely a function of global contagion. This also why fundamentals (economic performances, earnings, etc..) and market actions went on the opposite ways serves as proof of the disconnect between popular wisdom and reality.

[13] Yao, Shujie and Lou, Dan Chinese Stock Market Bubble: Inevitable Or Incidental? University of Nottingham

[14] Investmentmoats.com, Andy Xie: Housemaid indicator says Chinese Bubble near to burst, April 28, 2010

[15] See US Markets: What Small Investors Fleeing Stocks Means, August 23, 2010

[16] KPMG.com "If you're applauded, worry"

Worth Doing: Inflation Analytics Over Traditional Fundamentalism!

``Economics is not about goods and services; it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium. These constructions are only tools of reasoning. The sole task of economics is analysis of the actions of men, is the analysis of processes.”- Ludwig von Mises Logical Catallactics Versus Mathematical Catallactics, Chapter 16 of Human Action

Marketing guru Seth Godin has this fantastic advice on quality,

``When we talk about quality, it's easy to get confused.

``That's because there are two kinds of quality being discussed. The most common way it's talked about in business is "meeting specifications." An item has quality if it's built the way it was designed to be built.

``There's another sort of quality, though. This is the quality of, "is it worth doing?". The quality of specialness and humanity, of passion and remarkability.

``Hence the conflict. The first sort of quality is easy to mandate, reasonably easy to scale and it fits into a spreadsheet very nicely. I wonder if we're getting past that.

In essence, everything we do accounts for a tradeoff. When we make choices it’s always a measure of acting on values.

For instance, the “quality” of providing investment advisory is likewise a tradeoff. It’s a compromise between the interests of investors relative to the writer and or the publisher. It’s a choice on the analytical processes utilized to prove or disprove a subject. It’s a preference over the time horizon on the account of the investment theme/s covered. And it’s also a partiality on the recommendations derived from such investigations.

So “meeting specifications” which is the conventional sell side paradigm has mainly the following characteristics, it is:

-short term oriented (emphasis on momentum or technical approaches),

-frames studies based on “spreadsheet variety” (reduces financial analysis to historical performance than to address forward dynamics),

-serves to entertain more than to advance strategic thinking,

- promotes heuristics or cognitive biases

-upholds the reductionist perspective or the oversimplified depiction of how capital markets work and

-benefits the publisher more than the client (Agency Problem)

Yet many don’t realize this simply because this has been deeply ingrained into our mental faculties by self serving institutions that dominate the industry.

And instead of merely meeting the specifications which is the norm, here we offer the alternative-the “is it worth doing?” perspective.

Why?

-Because we realize that successful investing comes with the application of the series of "right" actions based on the “right” wisdom and rigorous discipline.

And with “right” wisdom comes the broader understanding of the seen and unseen effects of government policies that IMPACT asset markets or the economy more than just the simplistic observation that markets operate like an ordinary machine with quantified variables.

-Because government policies shape bubble cycles which underpins the performance of asset prices.

Think of it, if markets operate unambiguously on the platform of “valuations” or the assumption of the prevalence of rational based markets, then bubble cycles won’t exist.

Hence, the failure to understand policy directions or policy implications would be the Achilles Heels of any market participant aspiring success in this endeavor.

For instance, with nearly 90% of oil reserves or supplies under government or state owned institutions, any analysis of oil pricing dynamics predicated on sheer demand and supply without the inclusion of policy and political trends would be a serious folly or a severe misdiagnosis.

Of course, money printing by global central banks adds to the demand side of the oil equation. Moreover, price control policies can be an interim variable. The recent attempt to curb speculative trading in oil can be construed as a significant factor for the recent oil collapse in oil prices.

-And also because I try to keep in mind and heart Frederic Bastiat’s operating principle, ``Between a good and a bad economist this constitutes the whole difference - the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, - at the risk of a small present evil.”

In short, the seen and unseen effects of policy actions and political trends are the operating dynamics from which underlines our “is it worth doing?” perspective.

Financial Markets As Fingerprints

We have repeatedly argued against the mainstream and conventional view that micro fundamentals drives the markets [see Are Stock Market Prices Driven By Earnings or Inflation?].

Stock markets, for us, have been driven by principally monetary inflation, and secondarily from sentiment induced by such inflation dynamics. All the rest of the attendant stories (mergers, buyouts, fundamentals such as financial ratio, etc…) function merely as rationalizations that feeds on the public’s predominant dependence on heuristics as basis of decisions in a loose money landscape.

In an environment where liquidity is constrained, no stories or financial strength have escaped the wrath of the downside reratings pressure.

The disconnect between market price actions over the performance of corporate financials or the domestic economy have been conspicuous enough during the last bull (2003-2007) and bear cycles (2007-2008) to prove our assertion.

Moreover, up to this point our skeptics haven’t produced any strong evidence to refute our arguments. Instead we had been given a runaround, alluding to some regional securities as possible proof of exemptions.

Here we discovered that inflation and inflation driven sentiment seem to apply significantly even in the more sophisticated markets of Asia as well.

So, instead of weakening our arguments, the wider perspective has even reinforced it.

Moreover, financial markets shouldn’t be seen as operating in uniform conditions. Such reductionist view risks glossing over the genuine internal mechanisms driving the markets. The underlying structure of every national financial markets appear like fingerprints-they are unique.

For instance, they have different degrees of depth relative to the national economy as seen in Figure 1.

Figure 1: McKinsey Quarterly Mapping Global Capital Markets Fifth Annual

The McKinsey Quarterly map reveals of the extent of distinction of financial market depth across the world. Yet growth dynamics are underpinned by idiosyncratic national traits.

So it would be an “apples to oranges” fallacy to take the Philippines as an example to compare with the US markets or other markets in trying to ascertain the degree of “fundamentals” affecting price actions versus the inflation perspective.

Finding scant evidence that the Philippine market is driven by fundamentals, we’ll move to ascertain the impact of inflation to US markets-the bedrock of the capital markets.

The US has deeper and more sophisticated markets, where [as we pointed out in PSE: The Handicaps Of A One Directional Reward Based Platform] investors can be exposed to profit from opportunities in all market directions- up, down and consolidation, given the wide array of instruments to choose from, such as the Exchange Traded Funds, Options, Derivatives and other forms of securitization vehicles.

This leads to more pricing efficiency in relative and absolute terms.

This also implies that deeper and more efficient markets tend to be more complicated. Nonetheless this doesn't discount policy induced liquidity as a significant variable affecting asset pricing.

In lesser efficient markets as the Philippines or in many emerging markets, the lesser the sophistication and the insufficient depth accentuates the liquidity issue.

The fact that the broad based global meltdown in 2008 converged with almost all asset markets except the US dollar, had been a reflection of liquidity constraints as a pivotal factor among other variables.

S&P 500 Total Nominal Return Highlights Rapid Inflation Growth!

Since we don’t indulge in Ipse Dixitism, the proof in the pudding, for us, is always in the eating.

Figure 2: Investment Postcards: Components of Equity Returns

This excellent chart from Prieur Du Plessis’ Investment Postcards (see figure 2) showcases the categorized return of equity capital since 1871. That’s 138 years of history!

Says Mr. Plessis, ``Let’s go back to the total nominal return of 8.7% per annum and analyze its components. We already know that 2.2% per annum came from inflation. Real capital growth (i.e. price movements net of inflation) added another 1.8% per annum. Where did the rest of the return come from? Wait for it, dividends - yes, boring dividends, slavishly reinvested year after year, contributed 4.7% per annum. This represents more than half the total return over time!”

While it is true that dividends accounted for as the biggest growth factor in equity returns in the S&P 500 benchmark yet, where inflation so far has constituted about 25.3% (2.2%/8.7%) of total returns, what has been neglected is that rate of growth of inflation has far outpaced the growth clip of both capital and dividend growth.

Notice that inflation had been a factor only since the US Federal Reserve was born in 1913. Prior to 1913, equity returns had been purely dividends and capital growth.

And further notice that the share of inflation relative to total returns has rapidly accelerated since President Nixon ended the Bretton Woods standard by closing the gold window in August 1971 otherwise known as the Nixon Shock.

To add, the share of inflation has virtually eclipsed the growth in real capital!!!

In other words, investing paradigms predicated on the pre-inflation to moderate inflation era will unlikely work in an environment where inflation grows faster than dividends or capital.

Hence it is a folly to latch on to the beliefs of “fundamental driven” prices without the inclusion of policy induced inflation in the context of asset pricing.

This is a solid case where past performances don’t guarantee future outcomes!

To further add, if inflation has a growing material impact to the pricing of US equity securities, then the degree of correlation with the rest of the global markets must be significantly greater under the premise of market pricing efficiency.

Policy Induced Volatilities Against Mainstream Fundamentalism

Here is more feasting on the pudding (this should make me obese).

Figure 3: Hussman Funds Secular Bear Markets And The Volatility Of Inflation

Another outstanding chart, see figure 3, this time from William Hester of Hussman Funds.

Mr. Hester uses the volatility of inflation as a proxy for economic volatility.

In the chart, low inflation volatility extrapolates to higher price P/E multiples and vice versa.

Here it is clearly evident that when volatility is low, bubble valuations emerge (left window), whereas the regression to the mean from excessive valuations occurs when volatility of inflation or economic volatility is high (right window).

Mr. Hester adds, ``It's not only the level of volatility and uncertainty in the economy that matters to investors, but also the trend and the persistence in this uncertainty. Shrinking amounts of volatility in the economy creates an environment where investors are willing to pay higher and higher multiples for stocks, while growing uncertainty brings lower and lower multiples.” (bold highlight mine)

So, it isn’t just economic volatility (as signified by inflation) but uncertainty as a major contributory factor to the gyrations of price earning multiples.

And where does “uncertainty” emanate from?

It is rooted mostly from government intervention or political policies instituted by governments, such as protectionism, subsidies, higher taxes et. al.. or any policies that fosters “regime uncertainty” or ``pervasive uncertainty about the property-rights regime -- about what private owners can reliably expect the government to do in its actions that affect private owners' ability to control the use of their property, to reap the income it yields, and to transfer it to others on voluntarily acceptable terms” as defined by Professor Robert Higgs.

In actuality, Mr. Hester’s technical observations of the proximate correlations of inflation and price/earnings multiples is a reflection or a symptom of the operational phases of the business cycles.

As depicted by Hans F. Sennholz in the The Great Depression, ``Like the business cycles that had plagued the American economy in 1819–1820, 1839–1843, 1857–1860, 1873–1878, 1893–1897, and 1920–1921. In each case, government had generated a boom through easy money and credit, which was soon followed by the inevitable bust. The spectacular crash of 1929 followed five years of reckless credit expansion by the Federal Reserve System under the Coolidge administration.” (bold highlights mine)

So it would be plain shortsightedness for any serious market participants to blindly read historical “fundamental” performances and project these into future prices while discounting political or policy dimensions into asset pricing.

As we noted in last week’s Inflation Is The Global Political Choice, the financial and economic milieu has been hastily evolving post crash and is likely being dynamically reconfigured from where asset pricing will likewise reflect on such unfolding dynamics, ``the unfolding accounts of deglobalization amidst a reconfiguration of global trade, labor and capital flow dynamics, which used to be engineered around the US consumer, will likely be reinforced by an increasing trend of reregulations which may lead to creeping protectionism and reduced competition and where higher taxes may reduce productivity and effectively raise national cost structures, as discussed in Will Deglobalization Lead To Decoupling?”

Hence, any purported objectives to attain ALPHA without the context of the measurable impact from policy or political dimensions over the long term are inconsistent with the intended goals.

Instead, these signify as lamentable and plaintive quest for short term HOLY Grail pursuits which is not attributable to investing but to speculative punts.

Hence, traditional “fundamentalism” serves as nothing more than the search for rationalizations or excuses that would conform to cognitive biased based risk taking decisions.

It’s not objectivity, but heuristics (mental shortcuts or cognitive biases) which demands for traditional fundamentalism metrics since evolving market and economic realities and expectations don’t match.

Under A New Normal, Old Habits Die Hard

London School of Economics Professor Willem Buiter [in Can the US economy afford a Keynesian stimulus?] makes the same policy based analysis when he predicts that the US will prospectively underperform the global markets due to the political direction,

``There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future. A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain. It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations. I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude. I believe that markets - both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations - will make this clear. There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard.” (bold highlights mine)

Indeed, old habits, mainstream but antiquated beliefs are even more difficult to eliminate.

Figure 4: John Maudlin/Safehaven.com: Buddy, Can You Spare $5 Trillion?

In an environment where the dearth of capital will be overwhelmed by the expansive liabilities of global governments deficit spending policies [see figure 4], the underlying policy trends will determine, to a large extent, the dimensions of asset pricing dynamics.

And as we noted last week, deficits won’t be the key issue but the financing. Here a myriad of variables will likely come into play, ``the crux of the matter is that the financing aspect of the deficits is more important than the deficit itself. And here savings rate, foreign exchange reserves, economic growth, tax revenues, financial intermediation, regulatory framework, economic freedom, cost of doing business, inflation rates, demographic trends and portfolio flows will all come into play. So any experts making projections based on the issue of deficits alone, without the context of scale and source of financing, is likely misreading the entire picture.”

Yet, like us, PIMCO’s Bill Gross in his June Outlook sees a “New Normal” environment where investing strategies will have to be reshaped.

``It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.” (bold highlights mine)

So yes, ALPHA can only be achieved with respect to the understanding of the scope and scale of policy and political trends and its implication to the sundry financial assets and to the global and local economy as well as to industries. For instance, industries that have endured or will see expanded presence of the visible hand of governments will have systemic distortions that may nurture bubble like features of expanded volatility or could see underperformance over the long run.

And any models or assumptions built around traditional metrics are likely to be rendered less effective than one which incorporates political and policy based analysis.

In short, like it or not, in the environment of the New Normal, government inflation dynamics will function as the zeitgeist which determines financial asset pricing trends.

This brings us back to the issue of quality. For us, in almost every sense, it appears that the "is it worth doing?" perspective is the more profitable approach than simply abiding by the conventional “meeting specifications”.

Nonetheless for those who can’t rid themselves of such archaic habits, we suggest for them to enroll in local stock market forums where traditional fundamental information from diverse sellside sources or even rumor based information can possibly be obtained for free! Forums are recommended sources of information for short term players seeking market adrenalin and excitement.