US Markets: Unlikely A Reprise of 1998

``The good times of too-high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, . . . . there is a happy opportunity for ingenious mendacity.” Walter Bagehot, Lombard Street (p. 158)

Figure 6: Economagic: FED Cut case of 1998 versus 2002

The bulls argue that today’s actions has a precedent; the 1998 scenario. Then the FED applied its FIRST AID kit during the Long Term Capital Management (LTCM) induced liquidity crisis, where following the monetary treatment, its financial markets take off, as shown in Figure 6.

The leftmost red arrow shows of the FED cuts (red line) in response to the drop in the S&P (blue line) to our threshold levels. The S&P bottomed out in 3 months following the monetary remedy and speeded away for good.

However, this looks like apples to oranges comparison.

As seen above US economic growth (yellow green line) remained robust even during the selloff and looked unaffected. Second, US households and the global financial system were not as leveraged as it is today. Third, the source of stress came from external forces, following the 1997 Asian Financial Crisis. Russia went into a debt default which collapsed the highly geared LTCM run by two Nobel Laureates. And following the back-to-back crisis outside the US, money flows appeared to have shifted into the US markets which seems to have boosted the US dollar (green line), aside from its equity markets.

Today, the US economy has been growing below its average trend, US households have been levered to the eyeballs, the global financial system has exploded in size due to excessive leverage (the size of derivatives at $415 trillion is mind boggling enough!), global current account imbalances ballooned to record levels, and most importantly, the source of the present stress emanates from the US.

Fundamentally speaking, we don’t buy such arguments. However, we would keep an open mind and base our judgments on how the markets, especially the financial benchmarks, RESPONDS to the central bank impelled stimulus.

The bullish side critically DEPENDS on the central bank medicines to restore the present order. The bearish side is that central bank actions have always been SHORT-TERM in nature, and yet could go awry, as in the tech bust in 2000 (top red arrow). Besides, such inflationary actions usually involve longer term unintended consequences.

Finally, it is unlikely that a healing would occur soon. Even under the optimistic 1998 scenario, it took a QUARTER from peak-to-trough before a bottom was found. We are only about a month into this correction. It is too soon to tell.

Remember, NO trend goes in a straight line. There will always be massive relief rallies or bull traps within bear market cycles (refer to the Phisix 1997 chart). The latest Fed activities are likely to feed into the bullish insurgencies, but if problems continue to weigh on the financial system then eventually this would falter anew. Take such opportunities to exit instead as the risks prospects remain high.

Teetering At The EDGE Of A Market Meltdown, Global Central Banks To The RESCUE!

``Financial panics don’t happen during depressions…They happen on the brink of depressions. The claim the world is prosperous is beside the point.”-James Grant, the editor of Grant’s Interest Rate Observer.

In a span of 48 hours, global central banks in an apparent series of coordinated moves, under the threat of a market meltdown, conducted the LARGEST open market operations to inject liquidity into the world’s financial system since September 11, 2001.

The European Central Bank initiated the actions following a dramatic spike in overnight interest rates seemingly in reaction to a freeze on investor redemptions by France’s largest bank BNP Paribas on three of its investment funds that were invested in asset-backed securities (ABS) with significant exposures to US subprime mortgages. Asset backed securities is a type of bond collateralized by the cash flows from a specified pool of underlying assets (wikipedia.org) such as credit cards, auto loans and etc.

According to the Washington Post, ``The bank injected the equivalent of $84 billion into the financial system Friday "to assure orderly conditions in the euro money market," it said in a statement. The Federal Reserve added $38 billion to markets, the Bank of Japan $8.5 billion and the Reserve Bank of Australia $4.2 billion, signaling broad concern among central bankers. On Thursday, the European bank made a $130 billion infusion and the Fed added $24 billion.”

From Scott Lanman and Christian Vits of Bloomberg, ``Central banks in Norway and Switzerland also injected money into the financial system and countries including Denmark, Indonesia and South Korea said they're ready to provide cash.”

Let us hear from BNP Paribas the reason it suspended withdrawals (highlight mine), ``The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

Figure 1: New York Times: Spike in Interest Rates and Risk Aversion

Figure 1 from New York Times demonstrates how the markets suddenly seemed to have suddenly lost access to funding aggravated by a reversal in sentiment which appears to have raised risk awareness. How market psychology can swiftly change with a snap of the finger!

For instance, even when the FED rate is pegged at 5.25%, Bank of America had to add for its reserves last Thursday at 6%! In other words, because of the need by some banks to immediately secure reserves, they had to aggressively bid up the price of money. And only from open market operations by the FED did it normalize the rates.

This illustrates the implied “tightening” seen in the financial system as a consequence to the previous easy money policies which have likewise spawned financial engineering that resulted to the excessive leverage and speculation. The New York Times quotes Mr. Robert Barbera, the chief economist of ITG, a research firm (highlight mine), ``The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact…The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”

Now what used to be restricted to the confines of US mortgage lenders have now spread to the entire spectrum of international finance; from hedge funds to insurance companies (AIG) and now to banks! As Chris Hancock of Penny Sleuth aptly describes (highlight mine), ``The fear seems to be… No one really knows what these collateralized debt obligation (CDOs) are really worth. No one really knows who owns what. A farmer in France knows he holds a pension, but what that pension may be worth is anybody’s guess.”

Again this has not been limited mortgage issues as the credit woes has spread to the broader financial market, this excerpt from the New York Times (highlight mine), ``High-quality bonds issued by companies with sterling credit have not been immune to the rout either. Investment-grade bond issues fell to $30.4 billion in July — the lowest monthly total in five years — from $109 billion in June, according to Thomson.”

And since even the highest quality debts instruments had not been spared from the snowballing liquidity crunch, the diminishing appetite to take risks has started to curb activities even in the NON-FINANCIAL world.

In Asia alone, FinanceAsia identifies some of the emergent symptoms (highlight mine), ``Sure enough, Pakistani textile and fertilizer manufacturer Azgard Nine’s scheduled $260 million offering was postponed on Friday. Other companies in the pipeline such as Chinese property developer Hong Long Holdings, Indonesian mobile phone operator PT Mobile-8 Telekom, and Indonesian power company PT Cikarang Listrindo are also likely to experience considerable difficulties clearing their high-yield transactions. Nevertheless, chief investment officer Asian fixed-income and portfolio manager at Fidelity Funds, Andrew Wells says that credit spreads on Asian high-yield securities are now lower than for US high-yield. This indicates that investors view US high-yield as more risky than Asian high-yield.”

Naturally, with the epicenter of the credit tremors situated in the US, the perception of risk seen in the Asia-US yield curve is to be expected, although the contamination of the recent deterioration of credit conditions has obviously diffused to a broader segment of the global economy.

Ok, the basic dilemma in today’s setting is that with the recent financial alchemy, many portfolios of financial institutions around the world contain HIGHLY LEVERED instruments that are NOT openly traded or are highly illiquid. Such instruments in the past valuations had been DETERMINED by the ratings assessed by the credit rating agencies or by institutions that sold or distributed these, known as “Mark-to-Model”. Simply stated, many financial institutions who bought into these presumed that the US housing market had only ONE direction, never questioned on the financial INCENTIVES of the agencies that sold these products and most importantly never CONTEMPLATED on exit strategies or contingent actions arising from a reversal in the markets.

Now recognizing that some of these investments have been INFECTED by the US subprime problems, these financial entities are at a loss on how to value them since these have not been priced through the open markets. Since as we previously said, that losses on such levered positions necessitate margin calls, the corollary to this is the “COMMON FACTOR PROBLEM” where these financial institutions had no option but to sell assets that are most liquid (stocks or high quality debt) to cover their margins or borrow from another institution, ergo the contagion.

Moreover, there is the issue of RATING CREDIBILITY, some of the recently engineered financial products had been an amalgamation of inferior products (e.g. subprime) with that of mostly high quality debt products and had been eventually RATED as high quality ones. In short, there is also the issue of implied deceit or chicanery.

Considering the mounting losses, credit agencies have effectively been DOWNGRADING on a slew of such instruments, where markdowns constitute REVALUATIONS of portfolio values. For the others, losses would translate to large “haircuts” or even insolvencies. Therefore, one can expect losses on MORE institutions to crop up, and credit spreads to rise, as portfolios get “re-priced”. We borrowed Dennis Gartman’s quote last week, there is never one cockroach, now it appears that cockroaches have been appearing worldwide.

Essentially, all these show that many are today paying for the price of GREED, which had been stimulated by government inflationary monetary policies.

And because of the current dispersion of risk products into a WIDER pool of investors globally, the predicament of not knowing the worth of their portfolio assets have likewise led to the CLOSING of some credit channels and thus the liquidity crunch driven market carnage.

This is a very important germane insight lifted from the Financial Times (highlight mine), ``Marc Ostwald, fixed income strategist at Insinger de Beaufort, said: "There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas' statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch."

So fundamentally we have a crisis of confidence brought about by too much leverage that has incited to this panic. This is how Walter Bagehot in his book Lombard Street described panic (highlight mine), ``A panic grows by what it feeds on. . . . . A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. . . . . In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure, which causes them.”

If you think that the recent activities of global central banks will ARREST this unfortunate development, THINK AGAIN. Even as the ECB infused massive doses of liquidity to its starved markets for the second day, Washington Post describes the Friday’s outcome, ``European stock markets tumbled sharply. London's FTSE 100 index lost 3.7 percent, its largest drop in four years; France's CAC 40 fell 3.1 percent; and Germany's DAX dropped 1.5 percent.”

Yes, the US markets did rally from the chasms to close marginally lower (on Friday the Dow dropped 213 points but closed 31 down), but I highly suspect that these had been due to possibly more direct intervention from the President’s Working Group or as wikipedia.org explicates of the said highly secretive agency, ``The Group was established explicitly in response to events in the financial markets surrounding October 19, 1987 ("Black Monday") to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence" or subtly known as the Plunge Protection Team. But conspiracy theories are not our cup of tea.

The IMPORTANT POINT to understand is that with the series of seemingly coordinated government interventions around the world, such underlying motions acknowledges the severity of the problem largely underestimated by the world financial markets. The markets are only BEGINNING to adjust to the realization that they had applied leverage to the extreme levels, conditioned by monetary stimulus, which has resulted to the overestimation of business conditions or malinvestments in the terminology of the Austrian School of Economics. And it appears that the credit expansion cycle has turned.

In addition, since the present credit woes emanates from the US housing markets, then the ongoing HUGE ARM resets (as previously discussed) are likely to continue to hound the financial markets as foreclosures accelerate.

A further growing downside risk is that the US economy could enter into a RECESSION soon as consumers (estimated 76% of GDP) get tapped out from a 1-2-3 combo punches of DECLINING asset values of real estate and stocks and FESTERING credit conditions unmatched by any significant improvements in business investments and/or employment conditions, enhancing the odds of more downward financial markets readjustments.

Recently the US FEDERAL Reserves in its FOMC maintained that inflation was their main concern as a reason to maintain its present rate level. This will change soon.

Even hawks like St. Louie FED President Mr. William Poole, who recently denied that the FED would come to the rescue of the markets, or of FED Chief Ben Bernanke and US Treasury Secretary Paulson, both of whom claimed that the subprime worries would be limited have proven to be wrong, as rhetoric has NOW given way to palliatives.

The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon. And if the FED enacts a series of cuts, this underscores the risks of what we had mentioned above.

During the last two days, unknown to the public, the world financial markets teetered at a brink of a collapse.

Analyst John Maudlin quotes anonymously a financial expert (highlight mine) who piquantly describes the present situation, ``We came to the edge of the abyss in the financial markets this week, and then we looked over. The world does not understand how close we came to a total meltdown of the markets.”

A “Normal” Correction in the FACE of Massive Government Interventions? No Can Do!

``Mankind is condemned to repeat history, the first time as tragedy, the second time as farce.”-Karl Marx (1818-1883), German political philosopher and economist

I find it comical to see some analysts or experts completely in DENIAL to the present circumstances. Some see the present opportunities as a buying window, where they suggest that the present correction runs a “normal” course of action to the underlying trend. This runs contrary to common sense.

We pointed out that since global monetary authorities concertedly acted to salvage the present liquidity drought induced crisis, the fact that they ACTED on a supposed problem reflects a deeper degree of that problem than what had been mostly assumed. Yet, in the face of the synchronized central bank support worldwide, the continued violent reactions in the market in itself represents strong evidence of a fallout from such existing malaise.

In technical terms, yes, the correction in the US markets is within NORMAL ranges until now. But NO, you don’t see global central banks injecting liquidity regularly in the markets, do you? The last time they lent this degree of support was during the infamous September 11, 2001, which obviously means that the present imbroglio has even had MORE impact than 9/11, since today’s rescue package had been much larger in scale and scope (worldwide)!

NOW if the FED further acts to cut interest rates, which I expect to be very soon, (in a month or even less perhaps, depending on how the markets react), then such action should be construed as the recognition of Mr. Bernanke and Company of the imminence of the risks of degenerating economic conditions in response to the self-imposed tightening brought about by the continuing recession in the US real estate industry, which has now spread to other segments of the economy. This should imply that US markets may have FURTHER room to fall!

Ok let us revert to some technical standpoint to see how “Normal” things are.

Figure 2: Chart of the Day: September is the Worst Month for US Markets

Chartoftheday.com totaled the monthly average performance of the US major benchmark the Dow Jones Industrial Averages since 1950, as shown in Figure 2 and arrived at the statistical probability that going forward September could equal its WORST performance as it had been in the past 57 years.

This means that as August (barely changed from July 31^st) progresses which seem to be acting out an inflection point, September could even deliver more sufferings to the rear view mirror looking bulls. So essentially why take the risk today unless there is a tradeable short term window (but again risks prospects are high)?

Figure 3: BBC: Market Crashes Through The Ages

Two charts I compiled from BBC as shown in Figure 3 is the 10 biggest ONE DAY FALLS (leftmost bar chart) and 10 worst BEAR markets (rightmost bar chart) in the Dow Jones Industrial Averages.

Notice on the left chart that the 10 biggest declines had occurred mostly during October (5 times) followed by August (2 instances).

So aside from seasonal weakness for the month of September, August until October has proven to be a quarter previously SENSITIVE to the biggest one day losses for the Dow Jones. This implies that if HISTORY would ever rhyme again, then the present quarter has INCREASED the odds for the Dow Jones to be equally SUSCEPTIBLE to a HUGE one day decline!

Moreover, if today’s market has turned out to be an inflection point rather than a “normal” correction then the rightmost chart tell us that the average bearmarket in the US falls by around 40%!

And since our Phisix and most of the global markets has closely traced the movements or have been POSITIVELY CORRELATED with that of the US markets then think of WHAT a bearmarket in the US might possibly do to us or to the global markets, as shown in Figure 4.

Figure 4: The Previous Bear saw the Dow Jones HURT the HANG SENG and the PHISIX

When the 2000 tech bubble imploded in the US, the Dow Jones (black candle) plunged to about 7,200 (2002) from a high of about 11,900 for a 40% loss, as shown by the green trend channel.

In a similar timeframe, coincidentally the Hong Kong’s Hang Seng Index fell by about 52% (blue line) and the Phisix (red line) an even harder 62%!

And when fundamentals and technical viewpoints match, they tend to deliver quite a meaningful impact!

Of course I can always be wrong (which I hope I am--it will be a financial drought anew for us in the industry under a bearish environment--I should perhaps look for a new job).

Maybe confidence will be regained soon (I hope), the liquidity drought reverses and recovers (I hope) and credit conditions will ease (I hope) as the housing recession in the US finds a bottom (I hope).

But as a student of risk and market cycles, I wouldn’t bet on HOPE UNTIL the market proves me WRONG by stabilizing and eventually recovering. For the moment, this OBVIOUSLY isn’t the case.

Our goal is to preserve capital first and foremost.

Why Cutting Losses Is Better Than Depending On Hope

``Good traders, we think, don’t stand around and tell you how wonderful they are when they are right; most of time good traders only talk of their losers. Good traders’ reverse the natural tendency to attribute winning trades to brilliant analysis, and losing trades to bad luck; they understand what Livermore meant when he said, “In trading its better to do right, than be right.” The functional reality of this type of mindset is to limit the ego—which wants to seep in and control all.”-Jack Ross Crooks III, Black Swan Capital

Well to all those who still insist on clinging to the “ladder of hope” on this apparent monumental shift in market directions, I’d offer you a simple arithmetic which would enable you to reassess on your commitments.

Table 1: Returns Required to Break Even

Table 1 tells us that IT TAKES MORE EFFORT for the bulls to recover from their losses than to take losses and wait for the opportune moment to reenter the market.

For instance, a loss of 25% requires 33% in gains to offset the nominal losses (excluding transaction costs-which mean gains should be even larger). Similarly, a 50% loss translates to 100% (++) of gains in order to reverse the losses. As the losses worsen, so does the magnitude of gains required to neutralize such losses.

To sum it up, taking action by minimizing losses is A LOT BETTER than foolishly indulging in the hope of a recovery. As we always say, financial markets are mainly about opportunities management which should incorporate rationalizing costs relative to benefits.

Phisix: Undergoing A Cyclical Bear Market Within A Secular Bull Market Cycle?

``Over every mountain there is a path, although it may not be seen from the valley." - Theodore Roethke (1908-1963), American Poet

Finally, I think it is NORMAL for any countercyclical trend to operate within a structural long term trend. Because NO TREND GOES IN A STRAIGHT LINE, this means that a cyclical bear market can function WITHIN a secular bullmarket.

The Phisix has not been INSULAR to such circumstances, as shown in Figure 5.

Figure 5: Chartrus.com: Phisix had two 50% decline in the last bullmarket!

During the last secular bullmarket phase in 1986-1997, the Phisix encountered TWO cyclical bearmarkets, marked by the two arrows, which was evidently triggered by the two coup attempts of August 1987 and December 1989.

In between these reversals, the main Philippine benchmark lost by about 50-60%. Yet, this did not stop the Phisix from reaching the 3,400 level in 1997!

In the meantime, the present correction looks to me more like a typical countercyclical trend, under abnormal circumstances.

In the condition that the world does not fall into a DEPRESSION, I believe that the other MAJOR risk for my Phisix 10,000 is PROTECTIONISM.

The former is a risk that the global financial market has to FACE TODAY (why do you think global central banks intervened?) while the latter could be SUBSEQUENT to the former, as further losses could translate to escalating calls for MORE government intervention to assuage or mitigate their losses.

In short, the voting public will STIPULATE short term solutions in exchange for longer term unintended consequences and authorities will, in most probability, based on political incentives deliver it to them.

You should watch TV personality James Cramer go ballistic in a CNBC TV program captured in YouTube with his demand for the FED and Mr. Bernanke to immediately intervene during the latest bloodbath. We expect to see more of these hysterics from a broader field of market participants as the markets gets tested to the downside.

http://www.youtube.com/watch?v=cYPtCmdFCrc

Instead of entrapping ourselves with emotions that result to outbursts and tantrums which does not effectively relieve us of our losses, we should learn, understand and implement portfolio strategies on the premises that financial markets operate on cycles, which is the MOST important lesson I’ve learned on the markets throughout these years.

Technical View on the Phisix: The Path of Least Resistance is Down

``At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way...When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance." Chuck Prince, the CEO of Citigroup

At the start of the week, I was recently asked by a reader at my blog, if this signals the end of the global bullmarket.

To which my reply was, “As Scottish Philosopher Thomas Carlyle once wrote, ``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.

“What lies clearly at hand is the violent reactions seen in the world markets.

“If in the past, world markets have been buttressed by the abundance of liquidity, what appears to be a drag to the markets today is exactly the opposite.

“My understanding of the markets is that we are faced with serious headwinds and in my case would necessitate to react accordingly.

“If it is just a bear trap, then opportunities will allow us to earn again.

“If our fears translate to market mayhem then we'd be sulking on losses on a ladder of hope.”

Moreover, we’ve been asked if these developments could be indicative of a possible end to the recent streak of losses or a potential bottom which could present itself as a buying opportunity. Albeit in most instances, most of our queries manifested signs of consternation (beneath the surface) on the unfolding events in the markets.

The investing public is today groping for an answer on what they think as unseemly. Some have even attributed domestic political events as possible causes, which we believe are entirely irrelevant. Such is called the information bias - the tendency to seek information even when it cannot affect action (wikipedia.org) or the “Narrative fallacy” – our need to fit a story or pattern to a series of connected or disconnected facts (Nassim Taleb).

And yet there are those who have come to believe that every action in today’s market postulates a replay of the recent past (anchoring), or that recent countertrends will ONLY pose as buying opportunities as in February of this year (corrected by about 12.5% peak-to-trough), May 2006 (about 19%) or March 2005 (about 16%), where possibilities that our Phisix has entered into a cyclical bearmarket (within a secular bullmarket) has been ruled out.

Could this be a bottom? Yes it could. Could this be a buying opportunity? Perhaps, but I certainly wouldn’t bet on it.

Technically speaking, the Phisix from its July 13^th zenith at 3,820 has corrected by about 12.5% (peak-to-trough-assuming that the recent low is a bottom; again I wouldn’t bet on it). So essentially the recent market actions have been in line with its normal comport, which gives the bulls their confidence to declare a bottom.

However, we must be reminded that the Phisix has been largely DRIVEN by global money flows which have in MOST occasions reflected on the actions of mainly the US markets and the secondly the US dollar.

Put differently, we shouldn’t depend on the technical picture of the Phisix, unless our benchmark has concretely manifested signs of independence or distinction from the movements of the world equity markets. As we always say, a correlation is a correlation until it isn’t!

Figure 1 stockcharts.com: World Markets Breakdown!

And world markets have been showing formative signs of breaking down from medium term support levels as shown in Figure 1!

The US S & P 500 (at the topmost pane), the Dow Jones WORLD index (above pane below center window), and the Dow Jones Asia Pacific Index (lowest pane) have recently, similar to our Phisix (main window), broken below its key support levels.

With the fresh breakdowns in the international arena, momentum implies that our Phisix could likely be further affected. My conjecture is that the Phisix could possibly test the 3,200 level soon marked by the 200-day moving averages seen above, as the decline in global markets could accelerate. A break below 3,200 delivers us to the bear territory.

Not to be accused of data mining or selective reporting, we should equally note that emerging market indices are at present perched at similar key support levels BUT HAVE YET to breakdown as its peers. Our hypothesis on this divergence: since China’s market has been defiant of this global trend (e.g. Shanghai Composite index up 4.96% week-on-week, and 70.46% year-to-date), this has cushioned the declines reflected in the key emerging market indices.

Now, if one believes in the maxim that “a trend is our friend” then manifestations of these vital transgressions suggest of a REVERSAL in the bullish sentiment. In short, the burden proof now switches from the bears to the bulls, where the path of least resistance is most obviously down.

Well of course, given the recent rout we cannot discount the possibility that the market may undergo some technical bounce. However, we shouldn’t take this as signs to favor the bulls back in fashion unless key resistances will have been taken out.

I have been indisposed to take much of the required actions simply because I wanted to see added confirmations from overseas. However, the activities in the domestic market have been climactic.

US Mortgage Crisis Contagion: There is NEVER One Cockroach!

``This is the age of what I call Vehicular Finance. The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on. These vehicles can fit together like Russian dolls. By way of illustration – and, I fear, slipping for a moment into alphabet soup – SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans. (The diagram may, or may not, help!)”-Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England

Domestic mainstream analysts have correctly pointed out to the US subprime sector as one key catalyst to the recent selloffs, but obviously missed out is the carry trade linkages which have been an equally important contributor (Japanese Yen up .68% and Swiss Franc up 1.34% week-on-week). They have been simply echoing much of what mainstream international news have been saying instead of thinking independently.

In the meantime, experts in the local banking industry have been swift to dismiss the exposures or implied associations of the local financial institutions to the US subprime mess as much as with the Asian region.

While there may be some grain of truth to such assertion, the vast dispersion of risk assets has resulted to unforeseen losses surfacing in unexpected parts of the world. Following several blowups, which we have previously pointed out in some Australian hedge funds, German bank IBF (presently being bailed out by the government), German mutual fund German mutual fund Union Investment Asset Management Holding (halted redemptions) and France’s AXA (closed two subprime funds) have been the latest high profile ex-US casualties, according to Bloomberg.

We are not inclined to believe that this is the end of the episodes of the US housing subprime contagion, to borrow the quote of the illustrious Dennis Gartman of the Gartmanletters, ``There is never one cockroach”. Our primary concern is that this may just be the beginning or the proverbial “tip of the iceberg” and market behavior could be at present reflecting this.

In the following months or so, there is a big possibility that we are to countenance more institutional casualties emerging from the impact of the “one-two-three punch” of the US real estate industry to the subprime (structured finance-derivatives combo) jitters to the subsequent re-ratings in the global credit markets as well as in the equity markets. Of course, I could be wrong and truthfully, wish I would be wrong.

As we explained at our June 25 to 29 edition (see US Subprime Woes Spreading; Feedback Loop Dictated by Market Ticker), the problem is not much with the exposure of local banks to the US subprime imbroglio or related credit instruments, although this should NOT be discounted.

The basic problem lies with margin calls or the “common holder problem”. The Financial Times describes this as ``This is where investors from hedge funds to insurers are forced to sell more liquid assets, such as loans, to cover losses in assets that are difficult or impossible to sell, such as stricken mortgage-backed securities, or collateralised debt obligations built out of these.” (highlights mine).

We in fact used CALPERS, both with significant exposures to unrated CDOs (about $140 million) and to Philippine equity assets ($78.5 million as of 2005) as an example to our hypothetical scenario.

Since foreign money constitutes about half of the Peso trading volume in the PSE year to date, thus, our major question is; to what extent does foreign investors in Philippine assets have similar exposures to these imploding credit instruments?

Commodities Rise Amidst Market Turmoil; Gold Nears a Breakout

``Like dogs chasing their own tails”, it is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line". Seth Klarman The Margin of Safety (1991)

Figure 2: PSE Weekly declines in Percentages by sectors.

Well last week’s market action in the Philippine Stock Exchange certainly did not reflect on a limited scale of finance-based selling if such should embody subprime based apprehensions. But rather, what transpired was an across the board frenzied bloodbath, as shown in Figure 2.

The PSE had the worst week in terms of selling magnitude as depicted by its market internals since I started collating PSE data since mid 2002. There were 4 declining issues against every advancing ones during the five trading sessions.

While foreign flows registered marginal net inflows of Php 135 million, this was mainly due to the aggregate IPO related Special Block sales, which accounted for about 29% of the total peso volume turnover. Otherwise, market activities accounted for a net selling of P 1.22 billion!

Even as the Phisix dived by 4.73% over the week, reducing yearly gains to 12.4%, the Philippine Peso lost a paltry .07% from Php 45.72 to Php 45.84 relative to the US dollar.

Where we expected the mining sector to possibly provide for some semblance of divergence to a selloff, instead the reverse happened, the public indiscriminately disgorged speculative “bubbles” or Cult Stocks alongside mines with “fundamentals”.

Said differently, Cult Stocks, as defined by Investopedia.com ``A classification describing stocks that have a sizable investor following, despite the fact that the underlying company has somewhat insignificant fundamentals. Typically, investors are initially attracted to the company's potential and accumulate positions in speculation that its potential will be fulfilled, providing the investors with a substantial payout…While most of these cult stocks promise they will be the next big story after they make a new discovery or get the newest contract from the government, most do not provide investors with anything other than the story. (Does this ring a bell???-B. Te) Furthermore, these stocks typically generate very little, if any, revenue at all”, had been treated with a similar status with companies that has cash flow fundamentals!

As a result, the mining and oil sector bled the most by 13.69%. Such imperceptive selling binges speak loudly of how our markets function. Meanwhile the financial sector supposedly the parties affected by the credit woes lost only 5.34%.

Anyway, moving against the public’s consciousness, we see that amidst the global carnage, Gold is now making a renewed attempt to breach its zone of indecision marked by the continuation pattern of the symmetrical triangle shown in Figure 3.

Figure 3:stockcharts.com: Rising Commodities, Falling US dollar amidst Market turmoil

Of course gold has lately tracked the movements of the Euro, and the renewed decline in the US dollar index (topmost pane), where the latter’s rally appears to have lost steam and is once again headed towards the 35-year critical low (which increasingly adds to our global risk profile).

Meanwhile, commodities have largely remained upbeat as shown by the (above pane below the main window) the CRB-Reuters Index and the US WTIC sweet crude bellwether (lowest window), where the latter despite correcting 2% over the week to $75.48 a bbl also remains on a firm uptrend.

Oddly so, while we see the general mining indices abroad trail the overall market sentiment on the account of declining industrial metals, global gold mining indices have remained at the upper ranges of the resistance levels! Similar to the footsteps of gold prices.

Nonetheless, we are not to argue with the market. If mines are susceptible to emotionally charged bouts of panic, then they are unlikely to serve as insurance even if we are to see further strains of overseas-led market distraught. However, such conditions may change once gold makes a massive move to the upside, where foreign buying may spillover to the market and give a lift to these amidst the local punter’s myopia.

As I’ve said before, while mines and the commodities are arguably two distinct animals, since we lack a functioning commodity market (not the spurious type like the commodity market established in the 90s or the US centered defunct Manila International Futures Exchange) to buy the real thing, mining issues then serve as my proxy to ownership in gold. Obviously given the recent rout, the public does not appear to share this view.

ARM Resets: Clear and Present Danger to Global Financial Markets

``The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." Ludwig von Mises Human Action

Now as we have earlier noted, we believe that the credit markets will continue to reflect pressures from the persisting angst over the losses of illiquid structured finance/derivatives products which includes packages of subprime instruments now spilling over to the rest of the global financial markets.

Even high quality AAA instruments have now been marked down! According to one of our favorite author, Mr. John Maudlin (emphasis mine), ``Some BBB tranches of subprime paper are down by 60%. That is not surprising, given the quality of the loans that were made. What is very disturbing to investors is to watch what they thought was AAA credit already marked down by 10% or more. Some AA credits are down by as much as 25%. If you bought recent A rated mortgage paper you could be down by over 50%! That is ugly.”

So what was initially thought to be an insulated or “contained” event seems to be spreading towards the credit markets in general. As a result, rates of junk bonds, commercial real estate loans, and leveraged buyout financing have all tightened up. And tightening up means fewer activities or diminishing access to funding.

According to Mark Larson of Moneyandmarkets.com (highlights mine), ``As a result, we've seen activity in these markets drop dramatically. Compared to June, the total amount of corporate debt issued in July plunged 66%. The amount of sold junk bonds plummeted by a shocking 89%. And those Collateralized Debt Obligations (CDOs) that used to be so popular? JPMorgan Chase recently said sales of CDOs sank to just $9.1 billion in July from $43 billion in June.” For this week junk bond issuances have totally evaporated!

If mergers and acquisitions, corporate share buybacks and private equity deals had been previously the key drivers for the US equity markets then the sudden contraction of liquidity or access to funding combined with rising risk aversion by investors could have possibly resulted to a credit squeeze for the global financial markets addicted to leverage.

Quoting at length Mr. Doug Noland of the Credit Bubble Bulletin who aptly describes the present conditions (highlights mine),

``While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such the mortgage insurers, MGIC’s and Radian’s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during the final “blow-off” – total mortgage Credit doubled subsequent to the Greenspan Fed’s reckless post-tech Bubble “reflation.” Mortgage exposure now permeates the (global) system and is highly susceptible to “Ponzi Finance” dynamics.

``The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation - with major systemic ramifications.”

If the impairment proves to be systemic as Mr. Noland avers, then the likelihood is that we could be witnessing more downside volatilities for the financial markets in general. A disadvantage which used to be a widely touted advantage is that as risk instruments got to be widely distributed (spread risks), however, attempts to identify areas of concern has now become opaque even to regulators.

At present the financial markets could be at a denial stage, where the bulls will fight with its fullest intensity to restore or recapture its lost ground. If fundamental problems remain unresolved, the bulls will then likely encounter repeated failed attempts. This essentially leads into fear and desperation and eventually to panic and capitulation.

How good the chances of a recovery?

For Mr. William Gross, the Warren Buffett of bonds, Managing Director for PIMCO, it looks like this would be a protracted attrition like engagement. He says which we quote (emphasis mine), ``The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes – the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond.”

Figure 4: Mortgage Resets.com: ARM Resets as of January 2007

Those who bought into the peak of the US real estate cycle using teaser rates will end up paying amortizations of about 30% or more as rates adjust to reflect on their contracts (reset for every six months for 28 years after two years of low introductory rates), where some homeowners may be unable to cope with the higher payments (whose original intent was to earn by flipping “short-term” trading houses!).

With the present tightening trends in the lending standards by the surviving institutions and insufficient home equity shares as an offshoot to the declining real estate values, refinancing becomes less of an option for some homeowners while the threat of foreclosure looms.

Remember these household mortgages have been securitized, packaged and repackaged into different forms of highly levered instruments alongside other classes of debts, received improvised ratings from credit agencies as a consequence to the financial alchemy and sold to investors worldwide.

Now as foreclosures mount, investors or institutions holding on to these papers have been feeling the heat of the losses. Many of them will be forced to hold houses which they cannot liquidate in a market short of buyers. Credit lines to institutions with significant exposures are then cut and/or portfolio holdings significantly re-rated. Such losses subsequently eat up on their capital, which leads to their insolvency. Some of them go bankrupt; the others sell on the remaining liquid assets to settle on their outstanding liabilities and keep the company afloat. The general decline in collateral values (real estate, credit instruments and equities) essentially diminishes the ability to intermediate financing which then becomes a systemic risk.

If the credit markets today are feeling the unintended effects of $300 billion worth of resets in 2006 then we should expect more jitters to hit the credit markets as a tidal wave of more than $2 trillion of these loans (see Figure 4) or about a quarter of all mortgage loans outstanding are undergoing or will come up for interest rate adjustment in 2007 to 2008, according to mortgageresets.com.

For some, this imploding credit bubble is seen to have a potential widespread impact. Bear Stearns Chief Financial Officer Sam Molinaro was quoted by Reuters on Friday saying that ``Bond market turmoil sending investors fleeing from risk may be a worse predicament (highlight mine) than the 1980s stock market fall and Internet bubble burst.”

``These times are pretty significant in the fixed income market," Molinaro said on a conference call with analysts. "It's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme."

A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Puteo

``In a previous speech I suggested that periods of great market instability arise when three conditions are met. First, something happens that has widespread significance—is large enough to matter to lots of people. Second, the triggering event is a surprise. Ordinarily, events long anticipated are not troublesome because corrective action occurs before problems arise. Third, substantial uncertainty clouds resolution of the problem. It is especially difficult for investors to know what to do when the government's response to an unfolding situation is highly uncertain.”- William Poole, President, Federal Reserve Bank of St. Louis, Housing in the Macroeconomy

There are those who argue that the FED will remain hawkish and unlikely apply the Bernanke “Put” in the face of the unfolding liquidity squeeze.

A put option gives a buyer the right to sell a security/contract at a fixed price within a given period. Puts are essentially a hedge from declining prices. The Greenspan Put assumes that investors will be rescued by then Chairman Greenspan in response to an unraveling crisis with a series of interest rate cuts and injections of liquidity.

Figure 5: Yardeni.com: FED Cuts in at almost every crisis!

Figure 5 courtesy of Yardeni.com tells us that each time the US economy or financial markets faced an ongoing crisis, the PUT option was activated.

I think that under worsening conditions, Mr. Bernanke will be compelled to apply the PUT given the following:

First, it has been the FED's "winning formula" since ex-Chairman Greenspan took over.

Second, this path reflects on Bernanke's ideological inclination as signified by his speech at Milton Friedman's 90th birthday and his Helicopter (November 21, 2002) speech.

Third, I think being hawkish is merely rhetorical. Considering the complexity of today's financial instruments, several FED personalities, including St. Louis Reserve President William Poole (who has been stridently hawkish) has in the past acknowledged the uncertainties emanating from GSEs and untested financial instruments and their potential impact to the markets and the economy under severe or "testing" conditions.

Lastly, given the magnitude of financial leverage in today’s economy, I don't think the hawks can afford to tolerate a squeeze in liquidity, which should bring about the risks of debt induced deflation, something which Mr. Bernanke fears most.

Former Fed Chief Paul Volker acted to quell inflation in the late 70s because it was visibly exploding then. However today, such scenario has yet to egregiously manifest itself. Think of Gold $2,000 or more. Nonetheless, the act of preemption could spur negative political repercussions in the light of upcoming elections.

As Nicolas Taleb wrote, "Everybody knows that you need more prevention than treatment, but few reward acts of prevention. We glorify those who left their names in history books at the expense of those contributors about whom our books are silent. We are not just a superficial race (this may be curable to some extent); we are a very unfair one."

Since an ounce of prevention will unlikely lead to manifest rewards, based on incentives as a driving factor to the Fed’s decision making process, then they would likely opt for a treatment based action instead similar to its actions in 2000, as shown in Figure 6.

Figure 6: Economagic: FED Cuts as Rate as S&P fell!

To be sure, a cut in FED rates poses no guarantee that it will instantaneously boost the equity markets. The FED initiated its monetary actions by paring interest rates (red line) in late 2000 when the S&P 500 (blue line) has declined by as much as 15%! Yet, the rate cut did not deter the S&P from losing about 45% (peak to trough) as Fed rates nearly reached the floor at 1% in late 2002.

In the same context, we believe that similar circumstances would prompt for the FED to its traditional action, i.e. if US markets gets creamed by the worsening of credit conditions. Losses of anywhere between 10-15% could likely be the trigger.

However, anywhere in between now and 10% decline is likely to be a normal corrective phase and would NOT prompt any FED action.

In the meantime, taking defensive measures to preserve capital would likely be the best recourse under the current deteriorating conditions.

This could be a bear trap though, but given the fundamental developments, it seems unlikely so. I hope again I am wrong with such bearish outlook.

Finally, the PSE has introduced a new trading mechanism called the shorting facilities. It allows investors to profit from declining prices by borrowing shares and selling short an issue then buying back at a profit once the target decline in prices are reached. Inversely, cutting loss by closing an open position once shares move up instead of down.

I am not sure if this has been activated, although it sure is one good time to give them a test, especially if the Phisix comes off from a dead cat’s bounce.

A Nightmare on Wall Street; Currency Markets Turmoil

``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand." Thomas Carlyle (1795-1881) Scottish Philosopher, Essayist

Early this week, I had been asked why despite the adaptation of a bullish stance I sounded quite tentative. Well, the answer from the hindsight is quite obvious. We have been saying all along that since developments in the US markets appear to have been directing the path of the its counterparts in the global arena, if the financial markets were to reflect on the developments in the real economy, then we are at a loss of pertinent explanations except that we find massive expansion in today’s credit cycle and excessive risk taking behavior, underpinned by the expansionary policies assumed by the world’s central banks as basically responsible for the recent activities in today’s global financial marketplace.

Yet, regardless of the intensifying risks, financial markets have had their extended shindig, which seemed to uphold the impression that any inflection point could only be found in the distant future. Meanwhile, bearish analysts had been seen fading in the limelight as markets conspicuously contravened their outlooks as indices scaled to new heights. On the other hand, momentum investing appears to have gathered more following.

But suddenly, we found some of our apprehensions may have turned into a reality.

Last week, we described the possibility that as the US dollar Index approached its 35-year low, assaults on any major support levels have usually been accompanied by violent reactions. While we pointed out several factors that may lead the US dollar to breakdown into uncharted waters, we also raised the possibility that the US dollar index could in all probability stage a massive rebound from its lows. MOST of what we projected last week materialized as shown in Figure 1.

Figure 1: stockcharts.com: Currencies illuminate Market Stresses

At the start of the week, the US dollar index (+1.07% w-o-w) breached slightly below the 80s to a record low but fiercely recoiled after its attempted breakdown faltered (see panel above center window).

This coincided with a huge spike in the Japanese Yen (+2.06% w-o-w; see main window), which behind the scenes could have conspired to aggravate the turbulent conditions of several institutions holding assets already suffering from the worsening subprime implosions in the US.

And while both the Yen and the US dollar index surged, global markets represented by the US S & P 500 (upper pane below main window) and our own Phisix (lower pane) were thrashed (red circles). The blue vertical line signifies the demarcation timeline of the recent volatility chronicles.

In a perspective, the decline seen in the US markets in the weekly context has almost been similar in magnitude to the one seen late February (recall the “Shanghai Surprise”?), albeit a Bloomberg report calls it the worst week since 2002 (in allusion to the S&P 500--see how selective referencing can make a powerful difference in a presentation?) with about US $2 trillion in global market value wiped out.

This week the Dow Jones Industrials fell 4.23%, the S & P dropped 4.9% and the Nasdaq was lower 4.66% compared to end February’s 4.22%, 4.41% and 5.85%, respectively. This means that YES, the S & P was in accordance to the description by Bloomberg report but NOT so with the Dow Jones Industrials or the Nasdaq.

Similarly, for this week the Philippine Phisix got shellacked by 5.78%, however compared to February’s shakeout where the Phisix dived by a nasty 7.35%, the mitigated circumstances could have been cushioned by the latest BSP’s motion to reflate.

Anyway, following the said bloodbath early this year, the Phisix followed through with two successive weeks of decline, down 1.29% and 1.21% for a cumulative loss of nearly 10% before recovering. This is not to impress upon you that the Phisix will do a February reprise simply because the factors contributing to the recent actions have been dissimilar. Although our message is that streaks whether to the upsides or downsides occur. And given that the recent selloff resulted to some minor technical wreck (Phisix broke 50-day moving averages), momentum suggests to us that the path of least resistance could either be down or sideways.

Pockets of Resistance: Belated Effect or Incipient Decoupling?

Nevertheless, during February’s volatility, much of the world markets apparently sympathized with the actions of the US markets. However today, we see some peculiar divergences or markets behaving independently from the general activities in the equities frontier. For instance, while most people attribute February’s volatility to China, which we vehemently argued against, China’s Shanghai Composite rocketed by 7.06% and Shenzhen flew 10.84% (!) over the week in defiance to the prevailing sentiment across the globe--this should equally dispel the much touted China’s correlation with that of the world’s equity markets.

In addition, most of South Asia’s (Pakistan +2.09%, Sri Lanka +3.25%, Bangladesh +2.66%) and East European markets have likewise seemed insouciant to the recent turmoil to even end the week significantly higher. Even neighboring Thailand managed to eke out a 1.53% gain over the week.

Either we will be seeing belated effects on these markets or these pockets of aberration could be representative of emergent signs of financial markets “decoupling” with that of the highly leveraged US and western markets.