FEAR Index: 1987 versus 2008

Great chart from Bloomberg’s David Wilson:

From Bloomberg

From Mr. Wilson: ``The indicator is derived from prices of options on the S&P 100, as its name suggests. The current version, introduced five years ago, uses S&P 500 options and includes more contracts in the calculations. Their readings tend to be similar. The VIX closed yesterday at 62.90.

``In 1987, the old VIX behaved differently than it has this year because the plunge in stocks was ``a far quicker affair,'' Michael Shaoul, chief executive officer of Oscar Gruss & Son Inc., wrote yesterday in an e-mail. ``There was nothing like the same degree of economic problems at the time and no concerns about the global banking system outside of the fact that equity markets had crashed.''

``The old VIX peaked at 103.41 on Oct. 11 as the S&P 100 swung between a 3.2 percent gain and an 8.1 percent loss. The high was well below its record of 172.79 on Oct. 20, 1987, the day after the so-called Black Monday crash.”

From Chartrus.com: 1987 Crash

Stockcharts.com: Stock Crash 2008 Version

My comment: It is quite obvious that 1987 was a shocker. From the chart perspective, there was hardly any clue that a crash would occur.

This compared to 2007-2008, which had been in a slomo descending bear market until October. In other words, the 2008 bear market had essentially conditioned the public about deteriorating market and fundamental dynamics.

And if we go by “The Kübler-Ross grief cycle”:

Changing minds.com

The recent market crash could represent as the “Acceptance phase” or in stock market lingo “capitulation” phase.

Thus, the difference in the VIX index of 1987 and today was one of expectations.: people got dumbfounded by the precipitate “one day crash” behavior of 1987 (hence the sudden realization of vulnerability) whereas the 2008 crash had partly been a process of the Kübler-Ross grief cycle applied to the stock market.

The Bullish Case: It’s Blood On The Streets!

``Many momentous historical developments occur without the participants fully realizing what is happening.” George Soros

It’s been reported that losses in Wall Street has hit $2.4 trillion this week and $8.4 trillion for the year (Forbes) while the Phisix lost some P 554 billion or about or about $11 billion over the week (inquirer.net). On percentage basis, the Phisix lost almost the same as Wall Street down by over 18% and is down 45% year to date against the US bellwether Dow Jones Industrials at 39% and S & P 500 at 42%.

As we have pointed last week, the US seems fast catching up on the Phisix on an apparent race to the bottom. But the optimistic angle for the Phisix, which used to be high beta or “high risk-high return” seem to have transformed into “low beta”. In short, US markets appear to be underperforming the Phisix on the downside as well as the upside.

Yes admittedly the overwhelming power of the global bears eventually did catch up with my “divergence” view from which the Phisix struggled to maintain but eventually succumbed. But nonetheless, if such outperformance manages to hold then come the time when the global markets begin to stabilize or consolidate we should see a faster recovery for the Philippine benchmark.

True, the technical breach from support levels signals the return of the bear market, but it is unclear if we could go deeper.

The optimistic case:

Figure1 BBC: Market Crashes Through The Ages

In Figure 1 from BBC which we have shown in August 2007 and August 2008 highlights the worst performance of the Dow Jones Industrials in terms of one day falls and worst bear markets relative to the scale of losses.

Since each crisis has its own tale, this week’s drop 18.2% is one for the history books (marketwatch.com). Nonetheless, the 7.3% drop last Thursday will be as included as part of the largest one day loss and where the weekly loss looks like the extended variant (instead of one day, it became a one week) of Black Monday Crash of October 19^th 1987.

But from the technical, sentiment, valuation point of view these events are starting to look better.

One, the Dow Jones Industrial’s historical bear markets suggest that the biggest loss EXCLUDING the GREAT Depression has been around 40-50% (right pane) which means unless you believe that the US is faced with the prospects of a great depression, this record loss could herald a near, if not an interim, or even a major bottom.

The Dow Jones Industrials has already exceeded the degree of losses incurred from its 2000-2002 bear market (36%).

Figure 2: stockcharts.com: Fear Index and Capitulation Signals

Next, technical indicators point to severely oversold conditions to the point of ‘capitulation’ (see figure 2) or as per investopedia.com, ``capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.” (highlight mine)

Meanwhile the Fear index (topmost pane), as measured by the VIX is at confounding record highs. In previous occasions, the normal highs recorded were at over 30s (red vertical lines) which coincided with interim bottoms. This extraordinary fear is worth taking note of. Likewise the oversold conditions seem to be corroborated by the Relative Strength Index (RSI), seen at bottom pane, which is at below 30.

Figure 3: US Global Investors: Valuations Halved!

Nevertheless market actions appear to be pricing in a significant slowdown in global economies, according to Frank Holmes of US Global Investors (highlight mine), ``Trailing price-earnings ratios for global equities have been slashed in half since last year, as seen in the chart below. This is true regardless of whether financials are included in the calculation. In October 2007, the Factset Work Equity Index (10) generated a trailing P/E ratio of 18; that has now fallen to nine times earnings.

``Barclays made another important observation: The de-rating has been in response to the deteriorating economic climate. Basically, there’s been a traffic jam of inflation and credit shocks that has generated a global financial panic.”

So from the above perspective, we remember the famous contrarian advise of Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, who reaped a fortune from the ensuing panic during the Napoleon’s Battle of Waterloo as saying ``Buy when there's blood in the streets, even if the blood is your own!” (investopedia.com)

Phisix: Throwing The Baby Out of the Water

``An optimist sees an opportunity in every calamity; a pessimist sees a calamity in every opportunity.”-Winston Churchill

The recent selloff in most of the global equity markets has led some doomsday proponents to pronounce the toxicity of the emerging asset class as evidence by a drop in global forex reserves. They believe that a paucity of liquidity compounded by a US recession would lead to collapsing asset classes or some form of a crisis in emerging markets.

Unfortunately we can’t be convinced by such deflationary recoupling scenario promoted by perma bears simply because such argument has been predicated on the “fallacy of composition” or the generalization of the whole when it is only true for some its parts.

For instance, in the case of Russia which had been used as an example, which we recently also posted in An Epitome of A Full Scale Bear Market:: Russia, the country’s problem has been mostly from the political imbroglio where it got into a military engagement with neighboring Georgia. A compounding factor had been the liquidity crunch and falling commodity prices.

We aren’t seeing the same dynamics here in the Philippines.

Emerging Markets Are Not The Same

As we have repeatedly been arguing, for the Philippines it has not been about the question of risks from a recession, overleverage, oversupply, overvaluation, excessive speculation, stifling new government regulations or taxes, war, or even insolvency as seen in the case of the US or other developed economies.

Nor is it in Brazil whose housing or property industry remains sizzling hot according to the Business.view of the Economist.

For the Philippines despite the announcement of several banks with exposures to the Lehman bankruptcy, we had been right to say that the potential loses from these ‘toxic’ US instruments had been inconsequential relative to the banking industry’s capitalization or assets.

This from the inquirer.net (highlight mine),

``Seven banks in the Philippines have a total of $386 million in exposure to bankrupt US investment banking giant Lehman Brothers, according to the central bank’s estimates, but the banking system is widely believed to be in a good position to withstand the world’s worst financial shake-out.

``Even assuming zero recovery of their exposure to Lehman, the fallout for the seven banks is not expected to exceed one percent of their total assets.

``According to estimates by the central bank, Bangko Sentral ng Pilipinas (BSP), obtained by the Philippine Daily Inquirer, the retail tycoon Henry Sy’s Banco de Oro Unibank has the biggest exposure to Lehman at $134 million, followed by state-owned Development Bank of the Philippines (DBP) at $90 million.

``The BSP data show Metropolitan Bank and Trust Co. (Metrobank) has an exposure of $71 million, Rizal Commercial Banking Corp. (RCBC) $40 million, Standard Chartered Bank’s Manila branch $26 million, Bank of Commerce $15 million, and United Coconut Planters Bank (UCPB) $10 million.

``As a percentage of total assets of the individual banks, the exposures are as low as 0.5 percent and as high as 1.7 percent, according to the estimates, which were discussed at a meeting of the BSP policymaking body, the Monetary Board, on Thursday.”

As we have pointed out the main risk from the external link would come from the extent of foreign selling of domestic assets on the account of today’s mostly US based ‘deleveraging’ process. While there could still be some exposures to ‘tainted’ US financial instruments that may implode in the future, our idea is that this is likely to be material to impact normal business operations of the local banking industry.

Moreover, if some of the estimates are correct that over 50% of portfolio flows to Asia has been redeemed (as pointed out last week) then we are most likely to have seen the worst of the depressed foreign sentiment which leaves us with sympathy selling.

Figure 5: PSE Net Foreign Selling

The Phisix suffered its second worst week of the year which lost 6.93% compared to the week that ended January 18^th which accounted for a 9.57% loss. But relative to the degree of foreign selling, (see figure 5 orange arrows) the amount has been less intense compared to the similar circumstances when the Phisix had been subjected to the same fate.

In fact, last Thursday, which likewise accounted for a 4% drop following a similar decline in the US markets, the Phisix saw significant reduction of foreign selling to the tune of only Php 256 million compared to the daily range of Php 500-950 million a day during the past 2 weeks. This leaves us to hypothesize that mostly momentum driven domestic retail investors “threw out the baby with the bath water” in panic!

Of course, we are not saying the Phisix is riskfree or immune. Any risk from the Phisix would likely come from the political spectrum, if not from inflation or higher food prices, which so far have begun to decline. Of course, the recent concerted central bank pumping of liquidity into the global markets may reverse this decline. But if the global equity asset classes manage to absorb these injections, then the increase in consumer inflation could likely be gradual.

Debating Keynesian Concepts

Besides, we don’t buy into the Keynesian connection that consumer spending drives the economy which leads to the myth that the wilting US consumers will automatically lead to a bust in the emerging markets. As Gerard Jackson of Brookesnews explains, ``consumer demand springs from production, meaning you cannot consume what has not been produced. Therefore when consumers demand goods they are in effect exchanging what they produced for the products of other consumers. This is why the classical school considered money to be a veil that concealed the process of production and exchange from the public eye.”

The notion of a consumer driven economy actually stems from monetary inflation which has a detrimental effect in shaping an economy’s capital structure, to quote Gerard Jackson anew, ``Monetary manipulation not only severely distorts a country’s capital structure by misdirecting production it can also lead to the currency being overvalued which in turn could induce some manufacturers to shift operations offshore when undistorted marketed conditions would have persuaded them to remain in the US”.

And if trade or current account balances signified of the symptom of inflationary monetary policies, then the Phisix hasn’t been in the same shape or conditions as the US enough to unjustly merit a “toxic” grade. Moreover, based on the account of real savings or savings from the actual stuff we produce, the Philippines with its large informal economy equates to a cash based society with minuscule leverage applied, meaning much of our economy has been based real output than from the influences of distortive monetary policies.

Besides, much of the angst from the past Asian financial crisis still lingers, as evidenced by the minimal exposure of the banking system to rubbish US papers and conservative lending schemes by the banking system.

Moreover, valuations in Asia ex-Japan have nearly fallen to its multi-year “floor levels” which may translate to a looming bottom, see figure 6.

Figure 6: Matthews Asia: Asia’s Valuations Near Extreme Lows

To quote Robert J. Horrocks, PhD of Matthews Asia, ``the “decoupling” term has done a disservice to the entire economic debate. It has given the impression that economies must sever their links, and has denied the possibility that countries might simply transform their relationships whilst remaining close. The failure then of the world to decouple has lead to an overemphasis on the short-term decline in earnings and the worry that Asia will follow the U.S. into recession. Valuations in Asia have collapsed from the overexcited levels of late last year to far more sober levels that capture little of the exciting prospects for Asian growth. As such, they provide a long-term investor with a decent margin of safety. Framing the argument properly, I believe, helps to see the opportunities more clearly.” (highlight mine)

Like Mr Robert J. Horrocks, we have often stated that the decoupling recoupling debate is nothing but an invalid abstraction detached from the reality of the globalization process. And that from a valuations viewpoint, Asia has reached extreme lows and apparently has become detached from the real economy.

So while there might be additional sympathy selling pressures arising from the impact of the US financial crisis, this could be seen as opportunities from the facets of margin of safety to accumulate than to join the bandwagon of running for cover. Because markets are emotionally driven over the short term, they can always overshoot to the upside or the downside.

Recommendation: A Tradeable Rally Ahead?

Finally, some indicators suggest that we could have likewise bottomed out over the interim and a tradeable rally could be in the offing.

One, the restrictions on short selling of 799 financial stocks in the US and also adopted in the UK has moved the equity markets in seismic proportions last Friday. This should translate to a strong open in the PSE at the start of the week. However the effects from restriction curbs tend to be short term.

Two, as pointed out in my recent blog, Fear Index Pointing To Tradeable Rally Ahead?, each time the VIX or Fear Index peaks at above 30 it is usually followed by a bearmarket rally. The VIX or fear index hit a record high last week signifying outsized fear.

Three, the Phisix is coming from an oversold level, which means there could be more room for more upside traction.

So far, the recent lows have held its ground, giving us a clue of the possible strength of the aforementioned support level. The longer the Phisix maintains such support level the stronger it becomes.

Fourth, massive injections of bridge financing by global central banks tend to induce a period of lull following the recent turbulence. In addition, the proposed resurrection of the Resolution Trust Company RTC type of rescue package will entail a huge cost to US taxpayers. Over the longer perspective, this could lead to some capital reallocation of Asian capital to within the region and,

Lastly, any forthcoming rally, which would probably coincide with the closing of the seasonally weak September, may strengthen our case for a yearend rally.

Fear Index Pointing To Tradeable Rally Ahead?

Markets are being whacked globally in the aftermath of the combined troubles plaguing the US financial industry, particularly Lehman bankruptcy, Bank of America’s buyout of Merrill Lynch, aside from the capital raising and credit rating of insurer AIG.

There seems to be so much fear in today’s market climate.

One of the popular measure of Fear is the VIX index as defined by Wikipedia, ``VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.”

During the past year each time the VIX spiked beyond 30, the markets tend to temporarily bottom and usher in some short term “rebound” as shown below…

The blue vertical lines point to the historical “peaking” activities of the VIX index.

The temporary bottoms which it coincides with have been followed by rallies as shown by the trend lines of the S&P and the Phisix. But the important point is that the scale of past rallies have differed, of which is a very important determinant of the viability of the trade proposition.

Bottom Line: Further selling pressures could translate to “short term trading windows” for the Phisix. At the risk end, these may seem like "catching falling knives"; but given a longer term perspective, opportunities seem to present itself as buying at fire sale levels.