Stunning! Led by SM, 5-Issues Now Controls 48% of the PhiSYx; The US 4% S&P 500 Market Cap Share

Stunning! Led by SM, 5-Issues Now Controls 48% of the PhiSYx; The US 4% S&P 500 Market Cap Share

Thanks to the First Metro Investment’s ETF, the floating market cap or the official weight distribution of the headline index can be publicly viewed.

The updated distribution numbers are staggering! As of November 22, based on the free-float market cap, SM Investments controls a 15.8% share of the headline index!

In the week ending February 22 or the last date before the Philippine Stock Exchange unpublished this data, that number was only 13.34%. That would signify a big leap!

In the context of the full market cap weight, SM has 13.15% and is the king of listed issues. Full market cap = market price x outstanding shares.

Nevertheless, three of the Sy owned companies have a commanding 31.65% share of the full market cap index, and most importantly, 32.8% of the headline index.

That is to say, the MOST authoritative influence has been the SY group of companies!

In the meantime, based on the headline index, the top 5 companies control a whopping 48.4% of the index that's against the full market cap, where its share is at 44.16%! Sy group PLUS two other issues Ayala Land and Ayala Corp continues to snare a bigger role of the index. Lesser weighted issues become increasingly less relevant.

The irony is that the public refers to the index as the market. Just how valid is this popular notion when only 5 issues comprise nearly half share of the index?

The next question is how did it get here?

Since the genuine boom backed by huge volume climaxed in 2013, the index has increasingly has become dependent on the sustained cosmetic facelifting from unidentified managers after.

 

These mark-the-close actions benefited mostly the Sy group of companies, hence the skewed distribution that has brought about the widening gap in share weights against the rest of the field.

For example, the index closed down by 1.37% this week, but the decline could have been bigger had it not been to the 71.06 points or .9% end session pumps, with again, SM as a prime beneficiary.

 

And with mounting concentration, the increased dependency on SM and the SY group renders the index more susceptible to any adverse development on them.

In the US, the significant benchmark appears to be the 4% share weight of an issue relative to the S&P 500. In the past, when a company goes beyond this watershed number, a top in either the US markets or for that stock has been signaled.

Will the same apply to the Philippines?

And finally, in the Black Swan Theory, iconoclast Nassim Taleb’s offers the Turkey Problem to analogize the risk of ruin.

"A turkey is fed for 1,000 days by a butcher, and every day confirms to the turkey and the turkey’s economics department and the turkey’s risk management department and the turkey’s analytical department that the butcher loves turkeys, and every day brings more confidence to the statement. But on day 1,001 there will be a surprise for the turkey..."

That Turkey problem was in action last week. After soaring 3,800%, Hong Kong-listed Artgo Holdings collapsed 98%, after being rejected by the MSCI in the China index, in a single day! 

Past performance does not guarantee future results!

...

Chart of the Day: The Turkey Problem Applied to Volatility

Nassim Taleb's Turkey Problem...

The Turkey Problem in Action... The volatility index, the VIX (last week)!

Phisix: Will a Black Swan Event Occur in 2014?

2013 turned out to be a very interestingly volatile and surprising year. It was a year of marked by illusions and false hope.

Mainstream’s Aldous Huxley Syndrome

The Philippine Phisix appears to be playing out what I had expected: the business cycle, or the boom-bust cycle. Business cycles are highly sensitive to interest rate movements.

At the start of 2013 I wrote[1],

the direction of the Phisix and the Peso will ultimately be determined by the direction of domestic interest rates which will likewise reflect on global trends.

Global central banks have been tweaking the interest rate channel in order to subsidize the unsustainable record levels of government debts, recapitalize and bridge-finance the embattled and highly fragile banking industry, and subordinately, to rekindle a credit fueled boom.

Yet interest rates will ultimately be determined by market forces influenced from one or a combination of the following factors as I wrote one year back: the balance of demand and supply of credit, inflation expectations, perceptions of credit quality and of the scarcity or availability of capital.

The Philippine Phisix skyrocketed to new record highs during the first semester of the year only to see those gains vaporized by the year end.

During the first half of the year, I documented on how Philippine stocks has segued into the mania phase of the bubble cycle backed by parabolic rise by the Phisix index (for the first four months the local benchmark rose by over 5% each month!) and the feting or glorification of the inflationary boom via soaring prices of stocks and properties by the mainstream on a supposed miraculous “transformation[2]” of the Philippine economy backed by new paradigm hallelujahs such as the “Rising Star of Asia”[3], “We have the kind of economy that every country dreams of”[4], underpinned by credit rating upgrades, which behind the scenes were being inflated by a credit boom. This romanticization of inflationary boom is what George Soros calls in his ‘reflexivity theory’ as the stage of the flaw in perceptions and the climax[5].

While I discussed the possibility of a Phisix 10,000 as part of the inflationary boom process, all this depended on low interest rates.

But when US Federal Reserve chairman suddenly floated the idea of the ‘tapering’ or reduction of Large Scale Asset Purchases (LSAP) global equity markets shuddered as yields of US treasuries soared. Yields of US treasuries have already been creeping higher since July 2012 although the ‘taper talk’ accelerated such trend.

Since June 2013, ASEAN equity markets have struggled and diverged from developing markets as the latter went into a melt-up mode.

Just a week before the June meltdown I warned of the escalating risk environment due to the rising yields of Japanese Government Bonds (JGB) and US treasuries[6].

However, if the bond vigilantes continue to reassert their presence and spread, then this should put increasing pressure on risk assets around the world.

Essentially, the risk environment looks to be worsening. If interest rates continue with their uptrend then global bubbles may soon reach their maximum point of elasticity.

We are navigating in treacherous waters.

In early April precious metals and commodities felt the heat. Last week that role has been assumed by Japan’s financial markets. Which asset class or whose markets will be next?

Anyone from the mainstream has seen this?

Since the June meltdown, instead of examining their premises, the consensus has spent literally all their efforts relentlessly denying in media the existence of bear market which they see as an “anomaly” and from “irrational behavior”. 

They continue to ‘shout’ statistics, as if activities of the past signify a guaranteed outcome of the future, and as if the statistical data they use are incontrovertible. They ignore what prices have been signaling.

My favorite iconoclast and polemicist Nassim Nicolas Taleb calls this mainstream devotion on statistical numbers as the ‘Soviet-Harvard delusion’ or the unscientific overestimation of the reach scientific knowledge.

He writes[7], (bold mine)

Our idea is to avoid interference with things we don’t understand. Well, some people are prone to the opposite. The fragilista belongs to that category of persons who are usually in suit and tie, often on Fridays; he faces your jokes with icy solemnity, and tends to develop back problems early in life from sitting at a desk, riding airplanes, and studying newspapers. He is often involved in a strange ritual, something commonly called “a meeting.” Now, in addition to these traits, he defaults to thinking that what he doesn’t see is not there, or what he does not understand does not exist. At the core, he tends to mistake the unknown for the nonexistent.

English writer Aldous Huxley once admonished “Facts do not cease to exist because they are ignored.” Thus I would call mainstream’s rabid denial of reality the Aldous Huxley syndrome

Mainstream pundits like to dismiss the massive increase in debt which had supported the current boom. They use superficial comparisons (as debt to GDP) to justify current debt levels. They don’t seem to understand that debt tolerance function like individual thumbprints and thus are unique. They treat statistical data with unquestioning reverence.

I’ll point out one government statistical data which I recently discovered as fundamentally impaired. What I question here is not the premise, but the representativeness of the data.

The Philippine Bangko Sentral ng Pilipinas (BSP) recently came out with 2012 Flow of Funds report noting that the households had been key provider of savings for the fifth year[8].

Going through the BSP’s “technical notes”[9] or the methodology for construction of the flow of funds for the households, the BSP uses deposits based on the banking sector, loans provided by life insurances, GSIS, SSS, Philippine Crop Insurance and Home Development Mutual Fund, Small Business Guarantee and Finance Corporation and National Home Mortgage and Finance Corporation. They also include “Net equity of households in life insurances reserves and in pension funds”, “Currency holdings of the household” and estimated accounts payable by households, as well as “entrepreneurial activities of households” and “other unaccounted transactions in the domestic economy”[10]

But the BSP in her annual report covering the same year says that only 21.5 households are ‘banked’[11]. Penetration level of life insurance, according to the Philam Life, accounts for only 1.1% of the population[12]. SSS membership is about 30 million[13] or only about a third of the population. GSIS has only 1.1 million members[14]. These select institutions comprise the meat of formal system’s savings institutions from which most of the BSP’s data have been based.

Yet even if we look at the capital markets, the numbers resonate on the small inclusion of participants—the Phisix has 525,085 accounts as of 2012[15] or less than 1% of the population even if we include bank based UITFs or mutual funds and a very minute bond markets composed mainly of publicly listed entities.

So no matter how you dissect these figures, the reality is that much of the savings by local households have been kept in jars, cans or bottles or the proverbial “stashed under one's mattress”.

In the same way, credit has mostly been provided via the shadow banking sector particularly through “loan sharks”, “paluwagan” or pooled money, “hulugan” instalment credit or personal credit[16].

In short, the BSP cherry picks on their data to support a tenuous claim.

In fairness, the BSP has been candid enough to say, at their footnotes, that the database for the non-financial private sector covers only “the Top 8000 corporations” and that for the “lack of necessary details” their “framework may have resulted to misclassification of some transactions”.

But who reads footnotes or even technical notes?

The Secret of the Philippine Credit Bubble

This selective data mining has very significant implications on economic interpretation and analysis.

This only means that many parts of the informal economy (labor, banking and financial system, remittances[17]) has been almost as large as or are even bigger than their formal counterparts.

We can therefore extrapolate that the statistical economy has not been accurately representative of the real economy.

Yet the mainstream has been obsessed with statistical data which covers only the formal economy.

And in theory, the still largely untapped domestic banking system and capital markets by most of the citizenry hardly represents a sign of real economic growth for one principal reason: The major role of banks and capital markets is to intermediate savings and channel them into investments. With lack of savings, there will be a paucity of investments and subsequently real economic growth.

In short, the dearth of participation by a large segment of the Philippine society on formal financial institutions represents a structural deficiency for the domestic political economy.

Any wonder why the mainstream pundits with their abstruse econometric models can’t capture or can’t explain why Philippine investments[18] have remained sluggish despite a supposed ‘transformational’ boom today?

This also puts to the limelight questionable efforts or policies by the government to generate growth via “domestic demand”.

Yet the mainstream hardly explains where “demand” emanates from? Demand may come from the following factors: productivity growth, foreign money, savings, borrowing and the BSP’s printing money.

With hardly significant savings to tap, and with foreign flows hobbled by rigid capital controls, the corollary—shortage of investments can hardly extrapolate to a meaningful productivity growth or real economic growth.

So in recognition of such shortcoming, the BSP has piggybacked on the global central bank trend in using low interest rates (then the Greenspan Put) to generate ‘aggregate demand’.

As a side note; to my experience, a foreign individual bank account holder can barely make a direct transfer from his/her peso savings account to a US dollar account and vice versa without manually converting peso to foreign exchange and vice versa due to BSP regulations.

The BSP anticipated this credit boom and consequently concocted a policy called the Special Deposit Accounts (SDA) in 2006, which has been aimed at siphoning liquidity[19]. Eventually the SDA backfired via financial losses on the BSP books even as the credit boom intensified.

The BSP imposed a partial unwinding of the SDA which today has only exacerbated the credit boom.

Given the insufficient level of participation by residents in the banking sector and the capital markets, thus the major beneficiaries and risks from the zero bound rate impelled domestic credit boom meant to generate statistical growth have been concentrated to a few bank account owners, whom has accessed the credit markets. This in particular is weighted on the supply side, e.g. San Miguel

The credit boom thus spurred a domestic stock market and property bubble.

This has been the secret recipe of the so –called transformational booming economy.

Yet, the large unbanked sector now suffers from the consequences of a credit boom—rising price inflation.

Well didn’t I predict in 2010 for this property bubble to occur?

Here is what wrote in September 2010[20]

The current “boom” phase will not be limited to the stock market but will likely spread across domestic assets.

This means that over the coming years, the domestic property sector will likewise experience euphoria.

For all of the reasons mentioned above, external and internal liquidity, policy divergences between domestic and global economies, policy traction amplified by savings, suppressed real interest rate, the dearth of systemic leverage, the unimpaired banking system and underdeveloped markets—could underpin such dynamics.

My point is that these bubbles have been a product of the policy induced business cycle.

Also these can hardly represent real economic growth without structural improvements in the financial system via a financial deepening or increased participation by the population in the banking sector and in the capital markets. 

The chart from a recent World Bank report[21] represents a wonderful depiction of the distinctiveness of the distribution credit risks of ASEAN and China.

From the Philippine perspective, households indeed have very small debt exposure basically because of low penetration levels in the Philippine financial system. Whereas most of the insidious and covert debt build up has been in the financial, nonfinancial corporations and the government.

Ironically, Indonesia whom has very low debt levels has been one of the focal point of today’s financial market stresses which I discuss in details below.

This only shows that there are many complex variables that can serve as trigger/s to a potential credit event. Debt level is just one of them.

Why a Possible Black Swan Event in 2014?

I say that I expect a black swan event to occur that will affect the Phisix-ASEAN and perhaps or most likely the world markets and economies.

The black swan theory as conceived by Mr. Taleb has been founded on the idea that a low probability or an ‘outlier’ event largely unexpected by the public which ‘carries an extreme impact’ from which people “concoct explanations for its occurrence after the fact”[22]

The Turkey Problem signifies the simplified narrative of the black swan theory[23]. 

A Turkey is bought by the butcher who is fed and pampered from day 1 to day 1000. The Turkey gains weight through the feeding and nurturing process as time goes by.

From the Turkey’s point of view, the good days will be an everlasting thing. From the mainstream’s point of view “Every day” writes Mr. Taleb “confirms to its staff of analysts that Butchers love turkeys “with increased statistical confidence.””[24]

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table.

For the Turkey and the clueless mainstream, this serves as a black swan event, but not for the Butcher.

For me, the role of the butcher will be played by rising interest rates amidst soaring record debt levels.

Global public and private sector debt from both advanced economies and emerging has reached $223 trillion or 313% of the world’s gdp as of the end of 2012[25]. This must be far bigger today given the string of record borrowings in the capital markets for 2013, especially in the US (see below).

Moreover, recent reports say that there will be about $7.43 trillion of sovereign debt from developed economies and from the BRICs that will need to be refinanced in 2014. Such ‘refinancing needs’ account for about 10% of the global economy which comes amidst rising bond yields or interest rates[26].

While I believe that the latest Fed tapering has most likely been symbolical as the outgoing Fed Chair’s Ben Bernanke may desire to leave a legacy of initiating ‘exit strategy’ by tapering[27], the substantially narrowing trade and budget deficits and the deepening exposure by the Fed on US treasuries (the FED now holds 33.18% of all Ten Year Equivalents according to the Zero Hedge[28]) may compel the FED to do even more ‘tapering’. 

Such in essence may drain more liquidity from global financial system thereby magnifying the current landscape’s sensitivity to the risks of a major credit event.

And unlike 2009-2011 where monetary easing spiked commodities, bonds, stocks of advanced and emerging markets, today we seem to be witnessing a narrowing breadth of advancing financial securities. Only stock markets of developed economies and of the Europe’s crisis afflicted PIGS and a few frontier economies appear to be rising in face of slumping commodities, sovereign debt, BRICs and many major emerging markets equities. This narrowing of breadth appears to be a periphery-to-core dynamic inherent in a bubble cycle thus could be seen as a topping process.

Meanwhile the Turkey’s role will be played by momentum or yield chasers, punters and speculators egged by the mainstream worshippers of bubbles and political propagandists who will continue to ignore and dismiss present risks and advocate for more catching of falling knives for emerging markets securities.

And the melt-up phase of developed economy stock markets will be interpreted by mainstream cheerleaders with “increased statistical confidence”.

The potential trigger for a black swan event for 2014 may come from various sources, in no pecking order; China, ASEAN, the US, EU (France and the PIGs), Japan and other emerging markets (India, Brazil, Turkey, South Africa). Possibly a trigger will enough to provoke a domino effect.

I will not be discussing all of them here due to time constraints

Bottom line: the sustained and or increasing presence of the bond vigilantes will serve as key to the appearance or non-appearance of a Black Swan event in 2014.

As a side note: the dramatic fall on yields of US Treasuries last Friday due to lower than expected jobs, may buy some time and space or give breathing space for embattled markets. But I am in doubt if this US bond market rally will last.

[update: I adjusted for the font size]

---

[1] See What to Expect in 2013 January 7, 2013

[2] See More Media Spin on the Philippine Statistical Bubble Economy December 5, 2013

[3] See Phisix 7,000: Why Asia’s Rising Star is a Symptom of Mania April 29, 2013

[4] See Phisix: The Myth of the Consumer ‘Dream’ Economy July 22, 2013

[5] George Soros The Alchemy of Finance John Wiley & Sons page 58, Google Books

[6] See Phisix: Will Abenomics trigger a “Sell in May”? May 27, 2013

[7] Nassim Nicolas Taleb Antifragile: Things That Gain from Disorder Random House New York, p.9 Google Books

[8] Bangko Sentral ng Pilipinas 2012 Flow of Funds Reports Savings Across Sectors; Household Sector Remains as Top Net Funds Provider January 3, 2014

[9] Bangko Sentral ng Pilipinas Revised Technical Notes on the Philippine Flow of Funds

[10] Bangko Sentral ng Pilipinas FLOW OF FUNDS SUMMARY MATRIX, BY SECTOR 2012

[11] Bangko Sentral ng Pilipinas Annual Report 2012 p.50

[12] Yahoo.com Philippines Has The Least Insurance Penetration In Asia – Philam Survey, January 3, 2013

[13] Domini M. Torrevillas Garbage collectors are now SSS members Philstar.com October 17, 2013

[14] Government Service Insurance System GSIS prepares for UMID-compliant eCard enrollment

[15] see Phisix: Will the Fed’s Spiking of the Punchbowl Party Be Sustainable? September 23, 2013

[16] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20, 2013

[17] See Shopping Mall Bubble: Will Remittances, BPOs and the Informal Economy Save the Day?, January 21, 2013

[18]Agnes Isnawangsih, Vladimir Klyuev, Longmei Zhang The Big Split: Why Did Output Trajectories in the ASEAN-4 Diverge after the Global Financial Crisis? October 2013

[19] See Phisix: Escalating Risks from the Region and from Internal Bubbles December 9, 2013

[20] See The Upcoming Boom In The Philippine Property Sector September 12, 2010

[21] World Bank EAST ASIA AND PACIFIC ECONOMIC UPDATE Rebuilding Policy Buffers, Reinvigorating Growth October 2013 p.46

[22] Wikipedia.org Black Swan Theory Background

[23] See Dealing With Financial Market Information February 27, 2011

[24] Nassim Nicolas Taleb Op. cit p93

[25] Wall Street Real Time Economics Blog Number of the Week: Total World Debt Load at 313% of GDP May 11, 2013

[26] Bloomberg.com Bond Tab for Biggest Economies Seen at $7.43 Trillion in ’14 January 6, 2014

[27] See The Fed Tapers, Tremors on China’s Debt Market December 20, 2013

[28] Zero Hedge Chart Of The Day: The Fed Now Owns One Third Of The Entire US Bond Market December 3, 2013

Misrepresenting Frédéric Bastiat and the Black Swan Theory

Populist financial analyst John Mauldin seem to have misrepresented Frédéric Bastiat in his latest outlook.

Mr. Mauldin writes of Frédéric Bastiat,

He was a strong proponent of limited government and free trade, but he also advocated that subsidies (read, stimulus?) should be available for those in need, "... for urgent cases, the State should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions."

Really?

Here is the complete quotation from the great Frédéric Bastiat in Justice and fraternity, in Journal des Économistes, 15 June 1848, page 313 (Wikipedia.org) [quoted from Bastiat.org, bold emphasis mine, italics as per Mr. Mauldin’s quote]

When a great number of families, all of whom, whether in isolation or in association, need to work in order to live, to prosper, and to better themselves, pool some of their forces, what can they demand of this common force save the protection of all persons, all products of labor, all property, all rights, all interests? Is this anything else than universal justice? Evidently, the right of each is limited by the absolutely similar right of all the others. The law, then, can do no more than recognize this limit and see that it is respected. If it were to permit a few to infringe this limit, this would be to the detriment of others. The law would be unjust. It would be still more so if, instead of tolerating this encroachment, it ordered it.

Suppose property is involved, for example. The principle is that what each has produced by his labor belongs to him, the more so as this labor has been comparatively more or less skillful, continuous, successful, and, consequently, more or less productive. What if two workers wish to unite their forces, to share the common product according to mutually agreed-upon terms, or to exchange their products between them, or if one should make a loan or a gift to the other? What has this to do with the law? Nothing, it seems to me, if the law has only to require the fulfillment of contracts and to prevent or punish misrepresentation, violence, and fraud.

Does this mean that it forbids acts of self-sacrifice and generosity? Who could have such an idea? But will it go so far as to order them? This is precisely the point that divides economists from socialists. If the socialists mean that under extraordinary circumstances, for urgent cases, the state should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions, we will, of course, agree. This is done now; we desire that it be done better. There is, however, a point on this road that must not be passed; it is the point where governmental foresight would step in to replace individual foresight and thus destroy it. It is quite evident that organized charity would, in this case, do much more permanent harm than temporary good.

Bastiat was for subsidies (stimulus)? Go figure.

This is a nice example of doublespeak or the language that deliberately distorts or reverses the meaning of the words or statement—usually employed in politics. Yes just pick out an excerpt from which to stress one’s bias, even if these had been taken out of context.

Oh by the way, Mr. John Mauldin may have also misread the Black Swan Theory

He writes,

A Black Swan is a random event, something that takes us all by surprise. Economic Black Swans are actually quite rare. 9/11 and the aftermath was a true Black Swan.

This barely represents the definition of the theory

According to the book description of Nassim Taleb’s Black Swan: The Impact of Highly Improbable [bold emphasis mine]

A black swan is a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was…

Why do we not acknowledge the phenomenon of black swans until after they occur? Part of the answer, according to Taleb, is that humans are hardwired to learn specifics when they should be focused on generalities. We concentrate on things we already know and time and time again fail to take into consideration what we don’t know. We are, therefore, unable to truly estimate opportunities, too vulnerable to the impulse to simplify, narrate, and categorize, and not open enough to rewarding those who can imagine the “impossible.”

For years, Taleb has studied how we fool ourselves into thinking we know more than we actually do. We restrict our thinking to the irrelevant and inconsequential, while large events continue to surprise us and shape our world.

Black swans appear to be random when they are products of OUR failure to "take into consideration what we don’t know”. In short, the knowledge problem

For instance, 9/11 was considered a black swan for the victims, but not for the terrorists.

Mr. Taleb alludes to the Turkey problem as model for the Black Swan theory: For the turkey—after months of fattening who suddenly have been put into the dinner table for Thanksgiving—would be a (surprise) black swan, but not for the butcher.

This applies to the financial markets as well.

Expect a Continuation of the Risk ON-Risk OFF Environment

Today’s controversial split decision loss by World champion and Filipino boxing legend Manny Pacquiao serves as a vivid example of the self-imposed limits of nature on people.

As I pointed out on my blog[1], about 2 hours prior to the Pacquiao-Bradley match, Pacquiao has almost reached the natural speed limits of boxers, where the law of diminishing returns from ageing will turn the tide against him. Pacquiao’s contemporaries, the greatest boxers of the pasts, essentially sought retirement by mid-30s. Mr. Pacquiao is 33 and turns 34 this December.

And contrary to popular expectations, today’s match reveals that the venerable (in sports, not in politics) Filipino champion Manny Pacquiao is just like everyone else, a mortal. A victory from a rematch will not take away the laws of nature. The Pacquiao-Bradley fight heralds the twilight of the Pacquiao boxing era.

Pacquiao’s experience applies to the markets, the inflationism is a policy that will not and cannot last.

For the past few weeks, I have been emphasizing on this[2].

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.

Proven True: Sharp Volatility on Both Directions With A Downside Bias

This week, local markets confirmed my assessments.

Today’s dramatic volatilities have been representative of the gross distortion of the financial markets from sustained interventionism in various forms.

Unlike Pacquiao’s predicament, while it may be so that peak inflationism has yet to be reached, I believe that we are nearly there. All it would probably take is a global recession which will likely be met by the fully loaded firepower of central bankers.

Because the Phisix missed the selloff during the previous week as global markets got clobbered which I suspect has been due to some interventions by non-market forces, Monday’s 3.4% quasi-crash seems like a belated ventilation of the downside volatility that I have been concerned with.

Yet bulls remain in the hopeful that stock markets will continue to climb, I am not sure. Again, evidences don’t seem to confirm this and that the conditions I have stated above has yet to be met.

Also the current actions in the Phisix serve as a wonderful example of the tradeoffs between magnitude and frequency, where the frequency of accrued small gains can easily be wiped out by rare short bout/s of huge moves.

One of my favorite radical thinkers Nassim Nicolas Taleb called this the Turkey problem.

I explained in February of 2011[3]

The Turkey is fed from day 1 and so forth, and as a consequence gains weight through the feeding process.

From the Turkey’s point of view such largesse will persist.

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table. The turkey met the black swan.

The turkey problem is a construct of the folly of reading past performance into the future, and likewise the problem of frequency versus the magnitude, both of which serves as the cornerstone for Black Swan events.

In short, to avoid being the turkey means to understand the risk conditions that could lead to a cataclysmic black swan event (low probability, high impact event).

And this is why it has been IMPERATIVE to establish the underlying risk conditions affecting the marketplace rather than simply guessing on where short term fluctuations are headed for.

Given the current conditions, I wouldn’t want to be the turkey that ends up on the dinner table.

I would rather identify a trend that can provide me the opportunities for measured price moves in the face of established risk conditions given a time window to work on. Luck, to paraphrase the distinguished French chemist and microbiologist Louis Pasteur[4], favors the prepared.

In other words, determining the whereabouts of the stages of the boom bust cycle should be more of the priority than just the price levels.

Volatility has been ubiquitous and not limited to the Phisix. The US S&P 500 has been experiencing the same degree of turbulence.

Under current environment it would be very risky to interpret sporadic moves as sustainable trends.

Even gold has not been spared from drastic pendulum swings.

While I am still exceedingly bullish gold over the long run, I think there will equally be strong vacillations on both directions. Perhaps gold will undergo a consolidation phase first. But a severe downside move cannot be discounted.

Yet going back to the Phisix, the major Philippine bellwether was down only by 1.35% over the week which means 60% of Monday’s losses had been recovered.

At the world markets, this week’s performance has been in sharp contrast with that of the previous.

Monday’s quasi-crash by the Phisix has partially been offset by intra-week succession of gains whose rebound comes in the light of a global rally founded on multiple reports of rescues.

The markets cheered when ECB’s president Mario Draghi declared that “We monitor all developments closely and we stand ready to act”[5]. Also proposals for a grand rescue mechanism via a regional banking union had been floated[6] to the delight of steroid addicted markets.

Meanwhile, the US Federal Reserve chair Ben Bernanke employed the same I will backup the markets spiel with “As always, the Federal Reserve remains prepared to take action as needed to protect the US financial system and economy in the event that financial stresses escalate”[7] US markets soared.

India’s Prime Minister also chimed in to promise more engagement of fiscal spending on infrastructure projects[8].

Notice that outside Russia’s equity markets, the best gainers had been stock markets which made promises of rescues, particularly the India, US, Germany and France.

Ironically, the reaction has been different for those who actualized easing policies.

Australia pursued policy easing by chopping policy interest rates by 25 basis points for mortgages and business loans[9]. However, Australia’s stock market seems to have ignored the monetary stimulus by closing almost unchanged for this week.

More dramatically, China also did respond by cutting of interest rates for the first time since 2008, coupled with the further loosening of controls over lending and deposit rates[10]. Yet instead of recovering, China’s major equity bellwether, the Shanghai index slumped by 3.88% this week.

Again the Shanghai index also manifested the same volatility symptoms as with the rest. The difference is that the downside of China’s equity markets has been more elaborate and possibly signifies the admission of the severity or depth of China’s economic junctures and possibly too of the manifestations (or say protests) of the inadequacy of policy responses.

The point to emphasize is that financial markets has been vastly distorted and importantly, have been held hostage by politics.

As the illustrious Ayn Rand rightly explained[11],

When you see that trading is done, not by consent, but by compulsion - when you see that in order to produce, you need to obtain permission from men who produce nothing – when you see money flowing to those who deal, not in goods, but in favors – when you see that men get richer by graft and pull than by work, and your laws don't protect you against them, but protect them against you – when you see corruption being rewarded and honesty becoming a self-sacrifice – you may know that your society is doomed.

Risk ON-Risk OFF: Capital Flight, Bursting Bubbles and Political Gridlock

If the solution to the current crisis is about having more “stimulus”, then it would be ironic to have seen trillions upon trillions of dollars of “stimulus” thrown into the system, since 2008, and yet see the crisis linger, if not intensify.

Mainstream thinkers have been utterly lost or confused with the current situation for the simple reason that the commonsensical approach of keeping one’s house in order has been eschewed and substituted for the philosopher’s stone of bailouts and money printing. In a world based on aggregates, commonsense is a scarcity while fantasies are in abundance.

Where the problem has been about the lack of competitiveness and economic opportunities from too much regulation, bureaucracy and welfare spending, the propounded solution has been to “tax”, “spend”, “inflate”, “regulate” or “centralize” as if government can increase productivity by edict or by throwing money from helicopters.

Common sense also tells us that if these things worked we don’t need to work at all.

Yet when the law of diminishing returns for these interventionist measures becomes apparent, they ask for more of the same set of actions. The problem of debt requires to be solved by more debt (see above [12]). It’s like if your problem has been about alcohol then you should take more alcohol!

For the mainstream, money is wealth. Print money and everything gets solved. These have been the same prescription that has been complicating today’s crisis scenario with “exit” and “drachmaisation” therapy.

Yet instead of people willing to accept sacrifices for the “common good” as so expected by omniscient mainstream experts, reality reveals the opposite, people run and hide for cover.

There has been accelerating exodus of foreign money from Spain’s banking and financial system as shown above.

Dr Ed Yardeni notes[13],

According to data compiled by Spain’s central bank, foreigners reduced their deposits at Spanish credit institutions by 102.3 billion euros from a record high of 547.1 billion euros during June 2011 to 444.7 billion euros during March. In March alone, the outflow was 30.9 billion euros, and it probably accelerated during April and May…

The TARGET2 balances are more or less consistent with the trends in M2 money supply measures over the past year showing that they are falling in Spain and Greece while rising in Germany. On balance, M2 in the euro zone was up 2.8% y/y during April. This suggests that while the area's depositors are moving their funds from the periphery to the core countries, they aren’t fleeing the euro. However, the recent plunge in the euro suggests that they may be starting to shift funds into the US dollar.

Such exodus or capital flight out of the crisis affected EU nations has been destabilizing money supply conditions around the world.

Residents of these economies obviously don’t like to get robbed of their savings through the loss of purchasing power or through policies of devaluation. Devaluation theory is getting hit right smack on the faces of statist experts.

I pointed out last week that Swiss bonds have turned negative.

The same with Denmark’s 2 year bonds[14] as resident and foreign money flees Greece, Italy, Portugal or Spain. People from these nations would rather pay Swiss and Denmark’s central banks for safekeeping of their money than risk real losses from devaluation and the real risk of a collapse of the banking system.

The US Federal Reserve has partly countered the surges of capital flows by contracting their balance sheet.

This is perhaps comes along with the culmination of Operation Twist[15]—or the selling bonds with maturities of 3 years and below, which should lead to a decline of money supply and which eventually implies of negative effects on the markets. I would suspect that the gold markets have been sensing this thus the current volatility

Of course, once the episode of today’s capital flight from the Eurozone diminishes (which should amplify the money contraction), the FED will likely try to neutralize this by replacing or buy back of the assets which they earlier sold. Unfortunately the FED does not know beforehand when this will be happening, thus will only resort to reactive measures.

The uncertainty in the monetary actions should lead to heightened volatility that would be transmitted into the markets.

Hence, we should EXPECT very volatile markets ahead.

There could be another problem for further monetization of debts. Even if central bankers decide to print more money as another temporary patch to the current turmoil, the availability of their preferred asset[16], government bonds, has accounted for a steep decline. This implies that any future central bank purchases will likely be centered on mortgages and or privately issued securities (equities?).

The bottom line is that the combined effects of interventionism through price controls and bailouts which had prevented markets from clearing malinvestments or misallocated overpriced resources ALONG WITH sharp vacillations of capital flows as consequence of capital flight AND indecisive central bankers in the face of steroid dependent markets have been prompting for the recent market stresses.

This hasn’t been about imaginary ‘liquidity traps’ but of people’s subjective responses to perceived to political risks and policy uncertainties.

Yet as of this writing Spain has asked for $125 billion of rescue fund[17] as firewall from a potential fallout from the elections in Greece.

Does this imply a smooth sailing for the markets? We will see.

And as ramifications to the current dislocations in the monetary sphere out of policy indecisions and of political standoffs, it’s really hard to be unrealistically sanguine when forward indicators of factory activities have shown a synchronized decline[18]. The UK and Eurozone are in a recessionary mode, China is on the borderline while the US seems to be rolling over.

One offsetting factor has been today’s reported surge in China’s external trade[19]. Again this should be monitored rather than taken at face value given all of the above.

Yet we should ask; what if today’s (Pavlovian) stimulus conditioned markets become blasé to further promises from policy procrastination? How would the markets respond?

Again we need to seek clarity in all these than just recklessly plunging into markets centered on the belief that rescues would inherently come along and ride like a white knight to save the proverbial damsel in distress. The reality is that money does not grow on trees.

Thus we should expect the continuation of the Risk ON Risk OFF environment until concrete actions would have been taken.

It is only from here where we can have a sense of direction. And where we can assess and decide as to what position to take.

It is unfortunate that Pacquiao had to lose, but reality has long been staring at him which he denied, and may continue to deny. Many thought he was impervious and invincible too. They were all wrong.

The same with popular expectations for sustained bailouts, reality stares at our faces which we continue to deny. Yet the mounting intensity of crisis upon crisis has been admonishing us of the increasingly tenuous system. Public opinion will be proven wrong too.

Yet I am not saying that we should all be 100% cash. I am saying is that we should get less exposed to equities and overweight cash until conditions change. If the ECB and the FED collaborate on a maximum overdrive to stuff their balance sheets in exchange for green pieces of papers marked by Benjamin Franklins to the public, then we should make a swift move back into commodity based insurance positions. I suspect that come the next phase of interventions, it won’t be a risk ON risk OFF landscape but possibly one of STAGFLATION.

In the meantime be very careful out there.

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[1] See On Manny Pacquiao’s Boxing Career, June 10, 2012

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

[3] See Dealing With Financial Market Information February 27, 2012

[4] Wikipedia.org Louis Pasteur

[5] Bloomberg.com Draghi Says ECB Is Ready To Act As Growth Outlook Worsens, June 6, 2012

[6] See Eurozone’s Proposes Grand Bailout: Regional Banking Union, June 7, 2012

[7] Telegraph.co.uk Ben Bernanke says Fed ready to act if crisis intensifies, June 7, 2012

[8] See HOT: India Joins Pledge for Stimulus June 7, 2012

[9] Reuters.com ANZ cuts variable mortgage rates by 25 basis points June 8, 2012

[10] See HOT: China Cuts Lending Rates and Deposit Rates, June 7, 2012

[11] Rand, Ayn Atlas Shrugged Money padworny.com p. 387

[12] Price Tim Fixed Cobden Center March 12, 2012

[13] Yardeni, Ed Europe June 4, 2012 yardeni.com

[14] Bloomberg.com Denmark Government Bonds 2 Year Note Generic Bid Yield

[15] Wikipedia.org History of Federal Open Market Committee actions

[16] Zero Hedge, Presenting Dave Rosenberg's Complete Chartporn June 1, 2012

[17] Bloomberg.com Spain Seeks $125 Billion Bailout As Bank Crisis Worsens, June 10, 2012

[18] Yardeni Ed, Global Manufacturing June 5, 2012 yardeni.com

[19] Bloomberg.com China May Export Growth Tops Estimates As U.S. Demand Rises, June 10, 2012