US Equity Markets Welcomes Obama Re-election with a Thud!

What a celebration for the re-elected President.

From Bloomberg,

Stocks tumbled as Obama’s re-election set up a showdown with the Republican-controlled House over the budget, with the so-called fiscal cliff of more than $600 billion in tax increases and spending cuts slated to start in January unless Congress acts before then.

The Standard & Poor’s 500 Index (SPX) lost the most since June, tumbling 2.4 percent to close at 1,394.53. The retreat wiped out roughly $370 billion in market value from U.S. equities, according to data compiled by Bloomberg.

Don’t worry, for the Obama apologists the US Federal Reserve will ride to the rescue.

A day ago, Federal Reserve Bank of San Francisco President John Williams said that he expected the revitalized asset purchasing program or QE 30 (forever) to reach $600 billion into next year.

After yesterday’s elections, the ante seems to have been upped, where many expects the Fed’s program to exceed $1 trillion (I have been saying that both the FED and the ECB will be buying over $2 trillion)

From the same Bloomberg article,

A fiscal boost to the economy is probably off the table as President Barack Obama negotiates tax increases and spending cuts with leaders of a Democratic-controlled Senate and a House of Representatives led by Republicans, Edelstein said. That may leave only the Fed in the position of trying to boost the economy, and its third round of quantitative easing may extend through next year and climb past $1 trillion, said economists at JPMorgan Chase & Co. and Pierpont Securities LLC.

Supposedly political gridlock is there to blame, but this is simply a smokescreen for what in reality has been President Obama’s anti-business policies, which have only increased the risk profile and the cost of doing business and which will be reflected on higher hurdle rate for investors and entrepreneurs.

Economic freedom in the US has been on a marked decline.

From Fraser Institute: US ranking fell to 18th in 2010

From Heritage Foundation: US fell to 10^th place in the 2012 index

The distinguished Professor and author Thomas Sowell elaborates,

The media misconception today is that what we need to speed up economic recovery is to end gridlock in Washington and have bipartisan intervention in the economy. However plausible that may sound, it is contradicted repeatedly by history.

Unemployment was never in double digits in any of the twelve months following the stock-market crash of 1929. Only after politicians started intervening did unemployment reach double digits — and it stayed there throughout the rest of the 1930s.

There is nothing mysterious about an economy’s recovering on its own. Employers usually have incentives to employ and workers have incentives to look for jobs. Lenders have incentives to lend and borrowers have incentives to borrow — if politicians do not create needless complications and uncertainties.

The Obama administration is in its glory creating complications and uncertainties for business, ranging from runaway regulations to the unknowable future costs of Obamacare and taxes. Record amounts of idle cash held by businesses and financial institutions are a monument to the counterproductive effects of Barack Obama’s anti-business policies and rhetoric. That idle money could create lots of jobs — net jobs — if politics did not make it risky to invest.

So President Obama’s increasing reliance on the FED (most likely on Bernanke) will only lead to more volatile markets.

And volatile days have been a common feature since 2007.

The Bespoke Invest notes of the increasing “All or Nothing days” or advance decline breadth index “where the net daily A/D reading in the S&P 500 exceeds plus or minus 400”.

In other words, since the FED began intervening in the markets, stock market movements either floated or sank in tides. Such tidal motion is a symptom of the monetary policy influenced inflation (boom)-deflation (bust) volatilities.

Finally, Sovereign Man’s Simon Black succinctly illuminates on what to expect from the extension of Obama’s presidency

One point that I absolutely must make is this– after December 31st,

- Income tax rates are going up

- Capital gains rates are going up

- Rates on dividends are going up

- Estate and gift tax exclusions are going down. Dramatically.

Eventually the US government will run out of savings or wealth generators to tax and a crisis will emerge. And the US will default on its obligations.

Perhaps the markets has signaled what the great libertarian H. L Mencken wrote [A Little Book in C major (1916); later published in A Mencken Crestomathy (1949)].

Democracy is the theory that the common people know what they want, and deserve to get it good and hard.

Investing in the PSE: Will Negative Real Rates Generate Positive Real Returns?

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers including the government to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise. I believe that the Japanese government has already reached the point where a normalization of rates would create a fiscal crisis. David Einhorn

We are living in interesting times.

Negative Real Interest Rate as Stock Market Driver

In the Philippines, interest rates have considerably been below inflation rates.

Banks like the BPI[1], offers yields anywhere 2-2.75% for 364 days on their regular time deposit account, depending on the size of the account (as of November 15 to 21), whereas statistical Consumer Price Inflation rate has reached 5.2% last October[2].

Most people don’t realize that real money returns for the Peso has been negative or that savers have been losing money in terms of reduced purchasing power.

Curiously, inflation rates are even higher than the yields of domestic government bonds, from 1 to 10 years in maturity. This implies that bondholders of 10 years maturity and below are also getting squeezed from the current negative real interest rate regime (chart from Asian Bonds Online[3]).

Aside, the steep yield curve likewise induces borrow-short lend-long activities or maturity transformation which implies of higher future CPI rates as banks are incentivized to expand lending.

And since the yield curve has been steep even from last year, we are seeing credit activities ramping up.

From the BSP[4], (bold emphasis mine)

Growth in outstanding loans of commercial banks, net of banks’ reverse repurchase (RRP) placements with the BSP, accelerated in September to 21.7 percent from the previous month’s expansion of 19.8 percent. Meanwhile, the growth of bank lending inclusive of RRPs slowed down to 18.9 percent from 24.8 percent in August. Commercial banks’ loans have been growing steadily at double-digit growth rates since January 2011. On a month-on-month seasonally-adjusted basis, commercial banks’ lending in September grew by 1.0 percent for loans net of RRPs, while loans inclusive of RRPs fell by 2.0 percent.

Loans for production activities—which comprised 84.2 percent of commercial banks’ total loan portfolio—grew steadily by 22.9 percent in September from 21.5 percent a month earlier. Growth in consumer loans likewise accelerated to 17.9 percent from 13.4 percent in August, reflecting the rapid growth in lending across all types of household loans.

The expansion in production loans continued to be driven largely by higher lending to electricity, gas and water (which grew by 56.3 percent); manufacturing (24.2 percent); real estate, renting and business services (26.1 percent); wholesale and retail trade (29.8 percent); financial intermediation (32.8 percent); transportation, storage and communication (19.3 percent); and construction (17.6 percent). Moreover, with strong global demand driving growth in the mining and quarrying industry, loans to mining and quarrying more than tripled in September from a year ago, sustaining the three-digit growth rate since May 2011. Meanwhile, contractions were posted in lending to three production sectors, namely, health and social work (-4.9 percent), education (-10.0 percent), and agriculture, hunting and forestry (-3.5 percent).

From a mainstream economic viewpoint this will be seen as a good sign.

Theoretically low interest rate should reflect on the time preferences of individuals, where the preference to consume goods later rather than now (lower time preference) means that there should be an abundance of savings available for investments.

According to Mises.wiki[5]

The act of saving is a means through which man can achieve his ultimate goal, which is bettering his situation. Saving implies giving up some benefits at present - this is the price paid for the attainment of the end sought. The value of the price paid is called cost, and costs are equal to the value of the satisfaction which one must forego to attain the end aimed at.

The return on savings must be in excess of the cost of savings. If the costs are too high - if savings can’t better an individual’s life and well being - then saving will not be undertaken.

Consequently, the return on savings must be above the premium for man to agree to save. A positive time preference (i.e., the existence of a premium) precludes the natural emergence of a zero interest rate. Should a zero interest rate be imposed, this will abort all savings and lead to the destruction of the production structure. The premium of having goods now versus having them in the future is getting smaller with the increase in their stock. This, in turn, means that the required return on savings will be lower. An increase in the pool of funding sets the platform for lower interest rates.

Apart from time preferences, the purchasing power of money and business risk are important elements in the formation of interest. However, their importance is assessed in reference to the fundamental factor, which is time preference.

However as pointed out above a policy induced boom from manipulated interest rates distorts the production structure which will be misdirected towards investments in capital goods (higher stages of production) that leads to a bubble cycle (Austrian Business Cycle Theory—ABCT).

As I wrote last week[6],

Although I am not sure which sector should give the best returns over the short term, I am predisposed towards what Austrian economics calls as the higher order stages of production or the capital goods industries, which are likely the beneficiaries of the business cycle, specifically, mining, property-construction and energy, as well as financials whom are likely to serve as funding intermediaries for these projects.

Interestingly, even the relative performances by different sectors in the PSE seem to coincide or reflect on the distribution of credit growth as noted by the BSP.

For this week, except for Financial-Banking sector, the best gainers have been the mining index, followed by the industrial (mostly weighted on energy and utility companies) and the property sector. Here I am comparing apples to oranges because of the variances of time considerations between the PSE sectoral activities and loan portfolio growth in the real economy.

Yet the outperformance of the mining sector in the PSE can likewise be accounted for in the tripling of loans to the mining and quarrying industry.

Overall, the point is that the accelerating credit growth in capital good industries such as in mining, real estate and construction, power and financial intermediation appears to corroborate the boom bust process.

Another fascinating observation is that negative real interest rates may have altered the composition of trading activities seen during the current cycle in the Philippine Stock Exchange (PSE).

In the 2003-2007 boom cycle, foreign investors had largely been the dominant force in the daily trading activities at the PSE. Today, local participants appear to have wrested that role.

And the ascendancy of local investors seems to have provided resiliency to the Phisix during the recent shakeout.

The implication is that negative real interest rates may have driven many savers to speculate on the stock market to eke out positive real returns.

Yet if holding cash and near term bonds generates negative real returns then where to put one’s resources?

Every investment competes for your money. There will always be a tradeoff for any choices we make. Investments would mean a trade-off in terms of risk-reward and on relative assets.

Market Risk: Debating The Role of the ECB

There is no such thing as a risk free investment as inculcated to us by media, the academe or by mainstream institutions.

The concept of “risk-free” has been impressed upon us to justify the institutional rechanneling of private savings via the banking system into funding pet programs of politicians. And part of the process has been enabled by banking regulations such as the Basel Accord.

Yet such masquerade is presently being exposed by the markets. The bond spread of Italy and France (relative to the German Bund) has soared to record highs[7] as shown in the above chart (chartoftheday.com).

To add, the cost to insure liabilities of AAA credit rating France is now higher than the Philippines or compared to ASEAN-4[8]. This means that the credit standings applied by the government licensed or accredited credit rating agency cartel does not accurately reflect on the credit risks by developed economies plagued by the unsustainable welfare state.

And because financial markets have been defying whatever the EU governments has been imposing such as credit margin hikes[9] on Italian bonds and ban on short selling of Italian stocks[10], credit rating agencies appear as being pressured to downgrade the AAA credit rating of France[11].

The economics of the marketplace has been reasserting her ascendancy against welfare based politics.

Yet political impasse over the role of the European Central Bank as the “lender of last resort” has proven to be a seething issue that continues to unsettled financial markets.

While some key officials such as German Chancellor Angela Merkel[12], ECB’s Mario Draghi[13] and IMF’s John Lipsky[14] were allegedly against the carte blanche backstop role for the ECB, there has been a growing clarion clamor for the ECB to aggressively support the bond markets from France and from political personalities such as former German Chancellor Gerhard Schroeder[15], Portuguese President Anibal Cavaco Silva[16] and many more.

One popular analyst have even called the ECB’s role as either to “Print or Perish” for the Euro, which resonates with the popular call to inflate. Little do these inflation advocates realize that historical accounts of currency destruction have hardly been about the “deflationary spiral” but more about serial episodes of hyperinflations and or wars[17].

For the ECB to rapidly and intensify inflationism would be to “Print and Perish”.

Nonetheless, print and perish has been the name of the game for global central bankers.

But the supposed political stalemate over the ECB’s role appears as “smoke and mirrors” for me.

That’s because in reality, the ECB along with rest of major Central Banks except the US Federal Reserve has been scaling up their asset purchases as shown by the above chart[18].

Since 2008, major central banks have been ramping up asset purchases which makes today’s developments as unprecedented or entirely unique in modern history. So there hardly can be merit to claims that we are bound for “deflationary spiral” for as long as central banks continue to inundate the world with the liquidity approach to contain what truly are insolvency issues.

The ECB has reportedly an undeclared €20 billion weekly limit of bond purchases[19]. I would conjecture that rules, laws, regulations, policies or self-imposed limits change according to the convenience and the interests of politicians.

And recent reports suggest that European banks have been unloading heaps of sovereign debt issues.

So EU banks have been taking the opportunity to transfer their supposed “risk free” securities to the ECB in order to rehabilitate their balance sheets.

And the desire for the ECB to take on a more aggressive role can be seen through the implied missives from this New York Times article[20],

The dynamic of falling bond prices also undermines the capital position of the banks, since they are among the biggest holders of government bonds in many countries. As those assets plunge in value, banks cut back on lending and hoard capital, increasing the likelihood of a recession.

All these money printing won’t be sucked into a financial black hole, as they will have to flow somewhere.

Yet despite the current turbulence, I think that the current volatility may be ignoring such dynamic.

As a final note, if events in the Eurozone should turn out for the worst, the local and ASEAN economies may not be immune from such disruption, which may affect the region’s stock markets.

As Gerald Hwang of the Matthews Asian Fund writes[21],

Asian fixed income markets can have heavy foreign participation in both bonds and bank loans. The amount of participation from European banks is noteworthy in light of their exposure to European debt and the probability of shrinking balance sheets in the near future. European bank lending into Asia is greater than U.S. bank lending in the region; therefore, weakness in European bank balance sheets may tighten the financing environment for Asia’s borrowers more so than similar weakness in U.S. banks.

While European banks do have material exposure on Asia, I wouldn’t call less than 25% as substantial enough to possibly rock the boat. But again this depends on general market sentiment. Also, any tightening of credit conditions by Euro banks may be used as an opportunity by non-European banks to expand their market share.

Market Risk: US ‘Sequester’ Spending Cuts Will Be a Nonevent

The Philippine Stock Exchange’s Phisix has been up 2.41% on a year-to-date basis and has outperformed the majors and other Emerging Market contemporaries. But it is important to point out that such outperformance has still been dependent on the ebbs and flows of global markets, particularly the US (SPX).

Over the past weeks, we seem to be seeing renewed weakness in Europe (STOX50), China (SSEC) and US S&P 500 (SPX).

So far the stock markets of the Eurozone has, I think, already priced in an economic recession given the current bear market status. The Stoxx50 is still 19% down from the February 2011 high. Yet should the ECB intensify the asset purchases or inflationism we should see European stocks pick up.

Further, I think that US stock markets will likely steer the global markets rather than that of the EU. This means that an ascendant US markets should likely bolster the bullish case of the Phisix and of the ASEAN-4 and vice versa.

Yet another worry being promoted by some of the bears is the brewing gridlock by Congressional super committee over spending cuts that would result to sequester rules or automatic spending cut.

The Wall Street Journal editorial says that such concerns are exaggerated[22],

Under the sequester rules, roughly half of the spending cuts would come from defense and homeland security, and the other half from domestic programs such as roads, education, energy and housing. An automatic cut from every federal agency is far from an ideal way to write a budget, because it sets no priorities and largely exempts the major entitlements like Medicare and Medicaid.

But the sequester does have the virtue of imposing reductions in spending that Congress rarely agrees to on its own. The Congressional Budget Office estimates domestic programs would take a 7.8% cut, while defense programs would get sliced by 10%. Medicare spending, mostly payments to providers, would fall by 2%. This would yield $68 billion in savings in 2013, and more savings in future years by ratcheting down the baseline level of spending.

Given the spending increases of recent years, those cuts are hardly excessive. Domestic programs received a nearly $300 billion windfall under the 2009 stimulus, so a sequester would take back a little more than one-fifth in 2013. Total domestic discretionary spending doubled to $614 billion in 2010 from $298 billion in 2000. Even if there were a 10-year $1.2 trillion "cut," total discretionary spending would still rise by $83 billion by 2021 because those cuts are calculated from inflated "current services" projections.

Essentially, the $1.2 trillion sequester spending cuts will be spread over 10 years, and as mentioned above will be apportioned mostly towards defense, homeland security and domestic programs which hardly tackles on welfare entitlement programs.

The sequester or automatic spending cuts extrapolates to a cut on the rate of growth spending rather than real or actual cuts as shown above[23].

This only means that risks from the supposed political gridlock won’t be anywhere as disastrous as portrayed by political fanatics.

For the US markets, the reaccelerating growth of money supply should filter into and continue to provide support to her stock markets and the economy.

This week, the US economy posted strong growth which apparently surprised the mainstream[24]. Of course we understand this to be inflation boosted growth.

Barring any unforeseen events, I think this momentum should continue.

A Short Note On Commodities

Commodity markets experienced intensified downside volatility last week which many blamed on the Euro crisis.

While the Euro crisis may have aggravated sentiment, my guess is that these have been largely related to the liquidation process being undertaken by the trustee committee handling bankruptcy of MF Global Holdings who incidentally filed papers to set up the required accelerated filing of claims a day before the selloff[25].

Gold oil and copper simultaneously fell the following day.

I earlier noted that this should be expected[26] last week but apparently has been deferred until this week.

And I think that once the proceedings culminate, the upside trend for the commodity markets should resume.

Bottom line: Negative real interest rates and expanding balance sheets of major global central banks will impact asset prices differently. Nevertheless such dynamic will continue to provide support to the Phisix-ASEAN equity markets and the commodity markets.

On the other hand, unless a massive collapse occurs, political developments particularly in the Eurozone should spice up market actions.

So my guess is that the current domestic environment of negative real interest rates should bode well for investors of the PSE.

---

[1] BPI Expressonline Regular Time Deposit (Peso) November 15 to November 21, 2011

[2] Tradingeconomics.com Philippine Inflation rate

[3] AsianBondsOnline Philippine Government Bond Yields

[4] bsp.gov.ph Bank Lending Growth Expands Further in September, November 11, 2011

[5] Wiki.mises.org Saving and the Interest rate

[6] See Phisix-ASEAN Equities: Awaiting for the Confirmation of the Bullmarket, November 13, 2011

[7] Telegraph.co.uk Spread between French and German bonds hits record, November 9, 2011

[8] See Chart of the Day: France ‘Riskier’ than the Philippines, ASEAN, November 17, 2011

[9] Reuters.com MONEY MARKETS-Italian banks risk becoming dependent on ECB, November 10, 2011

[10] Reuters.com Italy to ban naked short-selling on stocks, November 11, 2011

[11] Guardian.co.uk Debts in France threaten top credit rating, November 15, 2011

[12] Bloomberg.com Merkel Rejects ECB as Crisis Backstop in Clash With France, November 17, 2011

[13] Washington Post, ECB leader Mario Draghi rebuffs calls for greater central bank role, November 19, 2011

[14] CNBC.com IMF’s Lipsky Backs Merkel Over ECB Powers November 18, 2011

[15] Reuters.com German ex-chancellor sees ECB steps in "last resort", November 18, 2011

[16] Bloomberg.com ECB as Lender of Last Resort Will Resolve Debt Crisis for Portugal’s Silva, November 12, 2011

[17] Hewitt Mike The Fate of Paper Money, January 5, 2009 DollarDaze.org

[18] Danske Bank, Bank of Japan on hold, still sees substantial downside risks November 16, 2011

[19] Reuters.com ECB has secret 20 billion euro bond-buying limit: report November 18, 2011

[20] New York Times Europe Fears a Credit Squeeze as Investors Sell Bond Holdings, November 18, 2011

[21] Hwang Gerald Capital Flows: Asia's Quiet Revolution Asia Insight November 2011 Matthews International Capital Management, LLC

[22] Wall Street Journal Editorial The Sequester Option, November 18, 2011

[23] Mitchell Daniel What Matters More to Republicans, Defending Taxpayers or Expanding Government?, November 18, 2011

[24] See Strong Performance of the US Economy Surprises the Mainstream November 19, 2011

[25] See MF Global Holding’s Liquidations and the November 17th Commodity Prices Rout, November 19, 2011

[26] See Client Accounts Transfer from MF Global Holdings may trigger Market Volatility Next Week, November 5, 2011

Phisix-ASEAN Market Volatility: Politically Induced Boom Bust Cycles

It’s hard enough for politicians to face the music, to dispense bad news, to make hard choices, allocate pain to constituencies whether it’s spending cut or tax increase. But when the Fed destroys the bond market, which is the benchmark for the whole capital market, and tells the Congress that you can borrow money for two years at eighteen basis points, which is -- as far as Washington’s concerned -- that’s a rounding error. It’s the same as free. When you’re giving that kind of signal, then there is no incentive, there’s no motivation for people to walk the plank and face down this monster of a fiscal deficit and imbalance that we have. Washington thinks you can kick the can down the road, the debt is more or less free, and we’ll get around to solving the problem. But today, let’s not make any tough choices. That’s where we are. - David Stockman

It’s the Boom Bust Cycle, Stupid

Why would global markets fall in sync in September 22^nd?

It would appear an idiotic idea to suggest that most people woke up on the wrong side of the bed and thus abruptly decided to dump equity holdings en masse.

It would also seem myopic to suggest that this has been a byproduct of liquidity trap[1], where monetary stimulus—low interest rates and an increase in money supply—had been the cause of this.

The chart above of the ASEAN markets has been emblematic of what I have been repeatedly saying long ago—the message of which has been encapsulated from my earlier remarks[2] during the bear market embers of November 2008, (bold highlights original)

The other important matter is that of the understanding of the mutually reinforcing dynamics of inflation and deflation. Deflation and inflation is like assessing the virtues of right and wrong- an ex-post measure of a previous action taken. An action and an attendant reaction. Yet, you can’t have deflation when there have been no preceding inflation. At present times, the reason government has been massively inflating is because they have been attempting to combat perceived threats of equally intense debt deflation…

Thus, reading political tea leaves seem likely a better gauge in determining how to invest in the stock markets.

Since 2009, ASEAN markets had climbed on the back of the intensive inflationism employed by global central banks mostly led by the US Federal Reserve, through its zero bound rates and asset purchases or Quantitative Easing (see black arrow).

If this has been about a global liquidity trap then obviously there would have been no antecedent boom in ASEAN or global market equities during the stated period (2009-2010).

Yet during the past quarter where the Eurozone debt crisis has escalated, exacerbated by visible signs of an economic slowdown in the US and parts of the global economy, global financial markets has been strained.

Yet financial market expectations, whom have been deeply addicted towards bailout policies, have increasingly embedded expectations of another US Federal Reserve rescue.

Such expectation had not been realized.

The Liquidity Trap Canard

Before proceeding, it is important to point out that despite the current financial market turmoil, the Eurozone has not been suffering from ‘deflation’ as a result of lack of ‘aggregate demand’.

On the contrary, the EU has exhibited symptoms of stagflation[3].

In the US, aside from exploding money supply, consumer and business loans have been materially improving.

5 year chart of Business Loans from St. Louis Federal Reserve

5 year chart of Consumer Loans from St. Louis Federal Reserve

Both charts depict that the current problem or market meltdown hasn’t been about liquidity traps.

Importantly consumer spending in the US has remained robust.

To quote Angel Martin [4]

real personal consumption expenditures have recovered from pre-recession levels. This recovery can be clearly seen in this graph, which shows quarterly data from the first quarter of 2006 to the second quarter of 2011.

So the recent downdraft seen in the financial markets has NOT been about liquidity traps, which has been fallaciously and deceptively peddled by some.

Politically Induced Monetary Paralysis

So what has been the market ruckus all about?

In a September speech prior to the Federal Open Meeting Committee[5] (FOMC) meeting, which decides on the setting of monetary policy, Federal Reserve chief Ben Bernanke hinted that he would consider the lengthening the duration of bond purchases and possibly include further Quantitative Easing as part of the measures to further ease credit conditions[6].

Apparently going into the FOMC meeting on September 22^nd, opponents of Bernanke’s asset purchasing program mounted a publicity assault which included several Republican legislators[7], and most importantly, even Mr. Bernanke’s predecessor Mr. Paul Volker at the New York Times[8].

Even the outcome of the FOMC meeting, where Mr. Bernanke’s telegraphed policy of manipulating the yield curve via “Operation Twist” had been formalized or announced, the decision arrived at had not been unanimous and reflected internal political divisions.

Except for the inattentive or those blinded by bias, it has been obvious that only half of what had been impliedly promised by the Mr. Bernanke became a reality.

The net result has been a global financial market jilted by Mr. Bernanke[9].

Lately, even Federal Reserve of the Bank of Dallas President Richard Fisher acknowledged that their institution has been under siege “from both ends of the political spectrum”[10].

Such political impasse is not only seen in the US Federal Reserve, but also over fiscal policies in Washington, as well as, the schisms over prospective measures required to deal with debt crisis in the Eurozone. A good example has been the rebuff US Treasury Secretary Tim Geithner received from the German Finance Minister[11].

This has been coined by some as ‘political paralysis’ which continues to plague the markets[12].

As proof of politically driven markets, this week’s furious rally in global markets has been bolstered by renewed expectations of bailouts, as the German parliament overwhelmingly voted to beef up their contributions to the European Financial Stability Facility bailout fund. There are still 6 of the 17 euro zone countries[13] whom will need to pass the agreement reached in July 21^st.

Rumors have also floated that IMF might expand her exposure towards Euro’s bailout to a whopping tune of $3.5 trillion[14], which means the world, including the Philippines, will be part of the rescue team to uphold and preserve the privileged status of Euro and US bankers as well as the Euro and US political class.

Yet all these seem to have helped market sentiment and partly reversed earlier losses.

The point of all of the above is to exhibit in essence, how global financial markets have been substantially dependent on policy steroids. In other words, markets have been mainly driven by politics than by economic forces or that the current state of financial markets has been highly politicized and whose price signals has been vastly distorted.

And most importantly, the latest financial market meltdown represents as convulsions over failed embedded expectations from the apparent withholding of the expansion of rescue programs from which the financial markets have been operating on.

To analogize, today’s jittery volatile markets are manifestations of what is usually called as ‘withdrawal syndromes’ or symptoms of distress or discomfort from a discontinuation of a frequented or regularized activity.

In addition, financial markets appear to be blasé on merely promises, and seem to be craving for concrete actions accompanied by “big package approach[15]” from global policymakers. In short, policymakers will have to positively surprise the markets with even larger dosages of bailouts.

Non-Recession Bear Markets

I would like to further point out that it is not a necessary condition where recessions presage bear markets.

While some global equity indices have broken into bear market territory[16], the US and ASEAN markets have not yet reached the 20% loss threshold levels enough to be classified as bear markets.

Bear markets occur mainly because of political actions that creates boom bust conditions. This has been the case of China and Bangladesh[17].

The US has also experienced TWO non-recession bear markets.

The first instance was in 1962 which was known as the Kennedy Slide[18] where the S&P fell 22.5%.

Ironically the Kennedy Slide coincided with the failed original experiment of Operation Twist in 1961, as Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack wrote in a 2004 paper[19],

Operation Twist does not seem to provide strong evidence in either direction as to the possible effects of changes in the composition of the central bank’s balance sheet.

Except that the authors thought that the limits to the size had been responsible for this policy inadequacy, and Ben Bernanke today is conducting this experiment in a very large scale.

The Kennedy Slide’s boom phase appears to be triggered by the dramatic lowering of interest rates following the recession of 1960-61.

The bear market turned out to be short lived as the S & P 500 had fully recovered in a about a year later.

The second non-recession bear market is the notorious Black Monday Crash of October 1987.

The expansionary policies of the Plaza Accord[20] which represented coordinated moves by major developed economies to depreciate the US dollar, fuelled a boom bust cycle which eventually paved way for the lurid global one day crash.

As the great Murray N. Rothbard wrote[21],

To put it simply: the reason for the crash was the credit boom generated by the double-digit monetary expansion engineered by the Fed in the last several years. For a few years, as always happens in Phase I of an inflation, prices went up less than the monetary inflation. This, the typical euphoric phase of inflation, was the "Reagan miracle" of cheap and abundant money, accompanied by moderate price increases.

By 1986, the main factors that had offset the monetary inflation and kept prices relatively low (the unusually high dollar and the OPEC collapse) had worked their way through the price system and disappeared. The next inevitable step was the return and acceleration of price inflation; inflation rose from about 1% in 1986 to about 5 % in 1987.

As a result, with the market sensitive to and expecting eventual reacceleration of inflation, interest rates began to rise sharply in 1987. Once interest rates rose (which had little or nothing to do with the budget deficit), a stock market crash was inevitable. The previous stock market boom had been built on the shaky foundation of the low interest rates from 1982 on.

The crash had been a worldwide phenomenon according to the Wikipedia.org[22]

By the end of October, stock markets in Hong Kong had fallen 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.45%, the United States 22.68%, and Canada 22.5%. New Zealand's market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover. (The terms Black Monday and Black Tuesday are also applied to October 28 and 29, 1929, which occurred after Black Thursday on October 24, which started the Stock Market Crash of 1929. In Australia and New Zealand the 1987 crash is also referred to as Black Tuesday because of the timezone difference.) The Black Monday decline was the largest one-day percentage decline in the Dow Jones. (Saturday, December 12, 1914, is sometimes erroneously cited as the largest one-day percentage decline of the DJIA. In reality, the ostensible decline of 24.39% was created retroactively by a redefinition of the DJIA in 1916.)

Yet many experts had been misled by the false signal from the flash crash to predict a recession, again from the same Wikipedia article,

Following the stock market crash, a group of 33 eminent economists from various nations met in Washington, D.C. in December 1987, and collectively predicted that “the next few years could be the most troubled since the 1930s”. However, the DJIA was positive for the 1987 calendar year. It opened on January 2, 1987, at 1,897 points and would close on December 31, 1987, at 1,939 points. The DJIA did not regain its August 25, 1987 closing high of 2,722 points until almost two years later.

And in typical fashion, central banks intuitively reacted to crash by pumping mass amounts of liquidity into the system[23].

It took 2 years for the S&P to return to its pre-crash level.

The non-recession bear markets reveal that in the case of the US, such an occurrence would likely be shallow and the recovery could be swift.

But it would different story in China as the Chinese government continues to battle with the unintended effects of their policies which has spilled over to the real estate or property markets. Apparently, China’s tightening policy drove money away from the stock market, which continues to drift near at September 2009 lows, but shifted them into the real estate sector.

In short, like the crisis afflicted West, the current depressed state of China’s stock market signifies as an extension of the bubble bust saga which crested in October 2007, a year ahead of the Lehman episode. China’s cycle remains unresolved.

Should the US equity markets suffer from a technical bear market arising from the current stalemate in Federal Reserve policies, but for as long as a recession won’t transpire from the current market distress, then the downside may be mitigated.

So far, the risk for a US recession has not been that strong and convincing as shown by the above recovery in lending.

Conclusion: Navigating Turbulent Waters Prudently

And as I concluded two weeks ago[24],

I would certainly watch the US Federal Reserve’s announcement and the ensuing market response.

If team Bernake will commence on a third series of QE (dependent on the size) or a cut in the interest rate on excess reserves (IOER), I would be aggressively bullish with the equity markets, not because of conventional fundamentals, but because massive doses of money injections will have to flow somewhere. Equity markets—particulary in Asia and the commodity markets will likely be major beneficiaries.

As a caveat, with markets being sustained by policy steroids, expect sharp volatilities in both directions.

The point of the above was that my expectations had conditionally been aligned to the clues presented by Ben Bernanke of putting into action further bailouts which apparently did not occur.

And since Mr. Ben Bernanke appears to be politically constrained to institute his preferred policies, it is my impression that he would be holding the financial markets hostage until political opposition to his policies would diminish that should pave way for QE3.0. This means that the balance of risks, in my view, have now been tilted towards the downside unless proven otherwise.

Remember, it has been a dogma of his that the elixir to US economy emanates from asset value determined ‘wealth effect’ spending via the transmission mechanism which he calls the Financial Accelerator[25]

To quote the BCA Research[26],

But until QE3 is credibly articulated by Bernanke, there could be more downside for risky assets and further upside for the dollar.

And converse to my abovestated condition or premises, and because I practice what I preach, I materially decreased exposure in the local markets, as I await further guidance from the actions of policymakers.

Although I still maintain a bullish bias, in order to play safe, I would presume a worst case scenario—current global bear markets are signifying a recession—as the dominant forces in operation.

It’s easy to falsify the worst case scenario with incoming policy actions, data and unfolding market events.

Alternatively, this means that for as long as a non-recession scenario becomes evident then it would be easy to position incrementally, hopefully with limited downside risks.

In other words, for as long as there remains no clarity in the policy stance, I see heightened uncertainty as governing the markets. Thus I would need to see the blanc de l'oeil or the French idiom for seeing ‘the white of their eyes’ before taking my shots.

Bottom line: In the understanding that incumbent markets have been driven by politics, reading political tea leaves or the causal realist approach will remain as my principal fundamental analytical methodology in ascertaining my degree of market level risk-reward exposure.

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[1] Wikipedia.org Liquidity trap

[2] See Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?, November 30, 2008

[3] See Stagflation, NOT DEFLATION, in the Eurozone, October 1, 2011

[4] Martin Angel The Stagnant U.S. Economy: A Graphical Complement to Higgs’s Contributions, Independent.org, September 23, 2011

[5] US Federal Reserve Federal Open Market Committee

[6] See US Mulls ‘official’ QE 3.0, Operation Twist AND Fiscal Stimulus, September 9, 2011

[7] Yahoo News Republican lawmakers warn Federal Reserve against action on economy, September 21, 2011

[8] See Paul Volker Swings at Ben Bernanke on Inflationism, September 20, 2011

[9] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms, September 22, 2011

[10] Bloomberg.com Fisher Says Central Bank Is Under Attack From Ron Paul, Barney Frank, September 28, 2011

[11] See German Minister Calls Tim Geithner’s Bailout Plan ‘Stupid’, September 28, 2011

[12] New York Times, Stocks Decline a Day After Fed Sets Latest Stimulus Measure, September 23, 2011

[13] New York Times, Germany Approves Bailout Expansion, Leaving Slovakia as Main Hurdle, September 29, 2011

[14] See Will IMF’s bailout of Euro Reach $ 3.5 trillion? September 30, 2011

[15] Johnson Simon What Would It Take to Save Europe?, New York Times September 29, 2011

[16] Bloomberg.com Global Stocks Drop 20% Into Bear Market as Debt Crisis Outweighs Profits, September 23, 2011

[17] See Can Bear Markets happen outside a Recession? China’s Shanghai and Bangladesh’s Dhaka Indices October 1, 2011

[18] Wikipedia.org Kennedy Slide of 1962

[19]Bernanke Ben S., Reinhart Vincent R., and Sack Brian P. Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, 2004 US Federal Reserve

[20] Wikipedia.org Plaza Accord

[21] Rothbard, Murray N. Nine Myths About The Crash, Making Economic Sense Mises.org

[22] Wikipedia.org Black Monday (1987)

[23] Lyons Gerard, Discovering if we learnt the lessons of Black Monday, thetimesonline.co.uk, October 19, 2009

[24] See Definitely Not a Reprise of 2008, Phisix-ASEAN Equities Still in Consolidation, September 18, 2011

[25] Bernanke Ben S. The Financial Accelerator and the Credit Channel, June 15, 2007 US Federal Reserve

[26] BCA Research U.S. Dollar: Waiting For More Policy Action, September 27, 2011