US Recession Watch: A Fed CUT in June or August?

``The job of the Federal Reserve is to take away the punchbowl just when the party is getting good." Former Fed Chairman William McChesney Martin

Instead of inflation as the culprit of the recent turmoil, key financial bellwethers appear to indicate of the contrary. As shown in Figure 1, the US Dollar index appears to have benefited from the recent shocks.

Figure 1: US Dollar Index Double bottom

A strong dollar denotes of a restrictive money environment. With global central banks in a consonant motion to lop off excess liquidity, these developments are hardly conducive for equity investments.

In addition, US 10-year yields have broken down (see Figure 2)!

Figure 2 US 10 Year benchmark Yields Breaking down?

Three things to bear in mind. One is that the present attempt by the benchmark US Treasury yields to breakdown from its support level could not be indicative of heightened INFLATIONARY expectations in distinction to what media or mainstream analysts have been speculating about.

Fixed income treasuries rally on the account of expected economic weakness. With global bonds (including emerging markets) appearing to show signals of bottoming out, the bond markets seems to suggests a coherent view of a global economic growth deceleration.

Second is that the present yield curve has gone flat with negative biases to fore. At less than 5%, relative to the FED interbank rate, the yield spread between the 10 year benchmark and the FED rate has gone marginally negative. If the FED continues to raise its short term rate on June 29^th to 5.25%, this effectively inverts the yield curve for as long as the longer end stays at present levels. The inverted yield curve indicator has correctly called on the majority of the recessionary economic downturns in the US during the 20^th century.

Mr. Van Hoisington and Lacy Hunt of the Hoisington Investment Management Company see similar risks in their recent outlook (emphasis mine)...

``In assessing the movement of these important financial economic and monetary leading indicators, it is our conclusion that a significant slowdown will embrace the United States before 2006 is completed. Furthermore, if the year over year growth rate of real M2 turns negative and the yield curve inverts for more than three months, the probability of recession will rise to over 50% on a statistical basis. Judgmentally we are already over 50%.”

This leads me to the third premise. That the bond markets dictate where the FED RATE direction goes and NOT the FED leading the bond markets. This is an important misconception deeply ingrained in the mindset of the average investors; that government policies dictate markets.

Figure 3 Courtesy of Elliott Wave’s European Market Watch

As shown in Figure 3 courtesy of Elliott Wave’s European Market Watch, the US treasury 3 month yields have in the past determined the policy actions of the Federal Reserves. Markets have essentially dictated on policy actions rather than what is commonly believed.

According to Mr. Vadim Pokhlebkim, Elliott Wave European market Watch (emphasis mine), ``Bond yields change daily, and central banks have no control over them: Yields (and prices) are set by the market. After years of observing the timing of monetary policy decisions, we’ve noticed one surprising fact: Central banks are almost never proactive when it comes to changing interest rates. Usually, they only react to what the bond market dictates. In other words, central banks’ decisions generally lag the bond market.”

Moreover, recent declines in the major US equity markets benchmarks may validate such bleak forecasts.

Figure 4 From Elliott Wave International, Dow Jones Industrial Average and the quarter-by-quarter performance of the US economy.

The stock market leads the economy, according to Robert Prechter of Elliott Wave international, ``Much of the time, the trends are allied, but if physics reigned in this realm, they would always be allied. They aren’t. The fourth quarter of 1987 saw the strongest GDP quarter in a 15 year span (from 1984 through 1999). That was also the biggest down quarter in stock prices for the entire period. Action in the economy does not produce reaction in stocks. The four-year period from March 1976 to March 1980 had not a single down quarter of GDP and included the biggest single positive quarter for 20 years in either side. Yet the DJIA lost 25% of its value during that period. Had you known the economic figures in advance and believed the financial laws are the same as physical laws, you would have bought stocks in both cases. You would have lost a lot of money.”

Last week, I mentioned that the incumbent Fed Chief Ben Bernanke and former Fed Chief Alan Greenspan acknowledged of the possibility of an ‘orderly’ housing industry induced economic growth ‘moderation’ in the US.

Since the US Federal Reserves future policy action is said to be “data dependent” which means its future course of action depends on its forecasts and on the effects on the incoming economic data on such forecasts, putting aside the assumption that the market dictates on the Fed policies, the $64 question is what if the Fed’s forecasts proves to be wrong as in the previous instances.

According to David Rosenberg, North American economist of Merrill Lynch (emphasis mine), ``the Fed overshot in the other direction in 2003 after overshooting to the upside in rates in 2000, and this is what business cycles are made of - policy mistakes."

``Bear in mind there was no evidence of a Nasdaq crash in spring of 2000 either. But given that Greenspan has been wrong at every critical juncture (emphasis mine) in his entire career, we know housing will collapse sooner or later...Actually, his position is peculiar, to say the least. He claimed there was a bubble in stocks in 1994; he embraced the productivity miracle in 1999-2000, looking for upside in the economy as shown by Fed minutes; then, after the bubble burst, claimed that bubbles could only be detected after they pop. Now he is claiming "very orderly and moderate cooling…where prices will not go down." This is, of course, reminiscent of esteemed economist Irving Fisher's statement in October 1929: "Stock prices have reached what looks like a permanently high plateau." wrote Mish Shedlock of whiskeyandgunpowder.com

Figure 5: Economagic.com: Dow Jones and the Fed Funds Rate

According to Bloomberg’s Prashant Rao and Deborah Finestone, ``Traders this week raised bets Fed policy makers will lift lending rates to 5.25 percent on June 29, as central bank officials suggested the Fed will remain vigilant to keep inflation from accelerating. Interest-rate futures are pricing in an 84 percent chance of a quarter-point increase in the Fed's key rate this month, up from 48 percent a week ago.”

In short, while today’s market could be pricing in another rate hike, market consensus has been essentially tussling over a quarter point rate increase and a pause. This leads us to the next UNSEEN variable. Figure 5, courtesy of economagic.com, shows of the Dow Jones Industrial Averages and the Fed Funds rate since 1990. Notice that at the onset of the past two recessions (1990 and 2001) marked by the red lines, had been accompanied by severe price declines in the Dow Jones benchmark. Subsequently, in both cases, the FED Rates COLLAPSES as liquidity was injected back into the system!

This suggests that IF the FED ends up chasing its own tail, as had been in the past, continued massive declines in the key equities benchmarks could be a harbinger of an ongoing recession instead of an impending one!! Notwithstanding concomitant to notable declines in benchmark US Treasury yields. And instead of a HIKE or a PAUSE, the likelihood is for a cut at the next June FOMC meeting or in August 8^th. Again this is strictly conditional on the performances of both the equities and bond markets.

As of Friday’s close at 10,891.92, the Dow Jones Industrial Average is a meager 6.6% away from its May 10^th high of 11,670.19, hardly a sign of a reversal YET. All these could be an instance of Aesop’s “Boy Who Cried Wolf” though. However, until the world financial market resolves its present impasses the probabilities of risks remains greater than potential returns.

As for the Philippine equity market, which had been highly dependent on foreign money, the ongoing global rush to exit levered positions on a declining economic growth backdrop is hardly an auspicious landscape for investing. Sans foreign money and sufficient local volume to meet the onslaught of foreign outflows, our Phisix becomes vulnerable to the vagaries of political sentiment. I would suggest for you to avoid catching the proverbial “falling knife.” Stay clear until the dust settles.

Global Markets: Free Fallin'

From Tom Petty's Free Fallin'...

And Im free, free fallin
Yeah Im free, free fallin
Free fallin, now Im free fallin, now im
Free fallin, now Im free fallin, now im

From Bloomberg: "Stocks in Europe, Asia and emerging markets tumbled on concern higher interest rates worldwide will stifle spending and earnings growth.

Europe's Dow Jones Stoxx 600 Index slid 2.4 percent to 306.65 at 9:41 a.m. in London, with mining and oil stocks leading a drop in all of the measure's 18 industry groups. Shares of BHP Billiton, the world's biggest mining company, and BP Plc, Europe's biggest oil company, both retreated.

Asian shares were headed for the biggest loss in two years. The Morgan Stanley Capital International Asia Pacific Index dropped 3.3 percent to 119.59, the most since May 10, 2004.

U.S. stock-index futures also slumped, and an MSCI measure for global emerging markets fell for a fourth day, wiping out this year's gains."

Stockcharts.com’s John Murphy: US DOLLAR AT CRUCIAL JUNCTURE

I noted that most key global financial market benchmarks have been trading in critical threshold levels. This means that at this juncture the markets will have to determine whether the recent shakeout serves as a signal of an “inflection point” or simply a typical “correction”.

In converse, in the case of the US Dollar index, the recent bounce off its steep decline could be extrapolated as either a “pause” in its dominant downdraft trend or a possibly signal a reversal/ “rally”. The interest rate expectation factors are likely to hold sway on the directional flows of this major indicator during the forthcoming trading sessions. As Stockcharts.com’s John Murphy notes, where the direction of the US dollar is headed for, the likely inverse path for the prices of commodities. I’d like to share Stockcharts.com’s John Murphy invaluable technical insights about the US Dollar Index...

Stockcharts.com’s John Murphy: US DOLLAR AT CRUCIAL JUNCTURE (emphasis mine)

The chart below compares the Dollar Index (green line) to the CRB Index (purple line) since last September. The main message to be drawn from the chart is that the two markets have been trending in opposite directions which is their natural tendency. Dollar peaks last November and again in March coincided with CRB upturns. A dollar bounce during the first quarter coincided with a CRB selloff. The recent minor bounce in the dollar may have contributed to the recent slide in commodities. That's why commodity traders need to watch the dollar especially closely at this point. That's because the dollar is at a crucial chart juncture.

Back in March I wrote a column about a possible "head and shoulders" bottom being formed by the Dollar Index. The next chart is an updated look at that possible chart pattern. The horizontal line drawn over the 2005 peaks near 92 is a possible "neckline". The middle trough formed at the start of 2005 is a possible "head", while the early 2004 trough is a possible "left shoulder". If the current selloff is a "right shoulder", it shouldn't fall below the left shoulder. The two green circles show that level to be just above 84. The Dollar Index is testing that support level at the moment. To turn the chart pattern bullish, the USD would have to rally from this level and exceed its neckline at 92. It's a long way from doing that. If it doesn't hold near 84, it could drop all the way back to its early 2005 low near 80. Technical indicators are mixed. The 9-week RSI is in oversold territory under 30. But the weekly MACD lines are still negative. Since I'm a believer in the maxim that it's easier to continue a trend than to reverse one, I think odds favor a dollar move to the downside. That would be even more likely if today's weak jobs data encouraged to Fed to take a pause in June. That would be bullish for gold and other commodity markets. That's why a lot rides on the trend of the dollar. That's also why the final chart is so worrisome. Going back to the mid-1980's, it shows the dollar in a long-term secular decline. It also shows how important the support line is along the 80 level. It held at the start of 2005 and prevented a major breakdown. If the current level of 84 doesn't hold, that long-term support line at 80 will be threatened again.

IMF Finance: Country Focus: ASEAN-4

The near-term growth outlook for the ASEAN-4 (Indonesia, Malaysia, Philippines, and Thailand) is favorable, thanks to strong export growth. But sustaining medium-term growth requires reviving domestic demand, especially investment.

Sources: IMF, World Economic Outlook database; CEIC Data Company LTD; and IMF staff calculations.

Heightened Volatilities Prevail

``There's no way all this debt can ever be paid off or even carried by stable economic systems. Forget that. This debt must be carried, handled, by ever increasing amounts of paper. That alone is a basis for perma-inflation. Maybe we've got a new word here -- "permaflation." Richard Russell of the Dow Theory Letters

ACTIVITIES in the global financial markets, as well as in the domestic markets, have shown some semblance of abatement from the recent intense selling pressures although indications are, in my point of view, that the probabilities of risks are still far greater than potential returns hence maintain my hands-off stance at the moment until signs of a clearer trend emerges.

Most of the present activities had been blamed towards the inflation ‘bugbear’ when as previously discussed, inflationary pressures have long been embedded into the world’s financial and economic landscape, whose transmission mechanism have been mostly been manifested through the rising variegated asset classes, which has eventually transfused into prices of essential goods and services.

Various keynote institutional analysts have labeled the present gyrations in the in the financial markets mostly as phraseological “risk premia repricing” or “rising risk aversion” or “normalization of risk factors”. In short, euphemisms for a fundamental change in market sentiment. Where global financial markets appeared to have factored in or assumed lesser degree of risks or adopted a high degree of complacency in the projecting the immediate past for pricing present trends, the precipitate alteration of directional paths underscores this shift of psychological outlook.

For instance, the US S & P 500 VIX index ($VIX), shown in Figure 1, or a market volatility indicator calculated by measuring option activities and is used as a gauge for investor sentiment has moseyed along for a great deal of time at near record low levels which means that investors in the US equity markets, particularly the S & P 500, have been rather “self-indulgent”.

Figure 1 S & P VIX Index Breakout

The recent breakout of the sentiment indicator is a reason to be cautious, according Ivan D. Martchev of Global View Points (emphasis mine),

``But while short-term market timing models all call for a dead-cat bounce, longer-term indicators suggest there’s much more potential for the selling to continue. The rapid selling in the Nasdaq 100, even after badly underperforming in 2006, is an indication that institutional investors have decided to get serious about playing defense. That's not going to change in a matter of days or even weeks.

``The S&P 500 Volatility Index (VIX) rose well above its October 2005 spike. This is the first time “the fear gauge” has risen above any major spike in its precipitous decline during the past three years. The index is clearly bottoming, carving higher lows after having declined as low as 9.88 in July 2005. This is very different behavior than what we’re used to. And given how depressed the VIX is, it can rise a long way from here.

Oooh...what a ghastly perspective in terms of technical outlook. Yet, this is what I have been saying long ago, to lift anew a great quote from the late economics professor Hyman Minsky, “Stability is unstable” or that the appearance of stability could be a breeding ground for complacency ergo future instability.

US Epicenter of Global Market Volatilities

Morgan Stanley’s Chief economist, Stephen Roach suggests that the hubbub in today’s financial markets has been an oddity, not been event driven, and could have been due to self-implosion due to excess speculation, quoting Mr. Roach from his Risk Bubble article (emphasis mine)

``It is on a par with the big reversals of the past. What is particularly interesting is that this outbreak of risk aversion has occurred in the absence of a financial crisis and in the absence of a major shift in the underlying fundamentals of the global economy...Absent the "pin" — normally thought to be an interest rate spike — investors have no fear of bubbles. Yet, this imagery is actually quite misleading. Yale Professor Robert Shiller has long stressed the tendency of asset bubbles to implode under their own weight (see Irrational Exuberance, second edition, 2005). In other words, it doesn’t always take that unpredictable "bolt from the blue" to send overvalued assets crashing back down to earth. To stretch the image a bit further, if the weakest portion of the bubble’s membrane fails, damage can quickly spread to the rest of the asset class.”

Since markets supposedly function as “future discounting mechanisms”, it should follow that in spite of the absence of the proverbial “pin”, these perturbations could be portentous of an impending dislocation rather than be reactive to one, in contrast to Mr. Roach’s opinion. Instead of being an outright effect, it could be construed as being ‘symptomatic’ to an underlying cause.

I have stated in my recent past outlooks that the markets could be adducing to a US centric-world economic growth slowdown or corollary to the belated effects of the coordinated tightening by Global central banks and to even the resonant calls on the ramifications of the present curtailment of the YEN carry trade arbitrage.

Empirical evidences appear to bear me out:

One, US Fed Chief Bernanke sees a housing slowdown, recently CNN Money quotes Mr. Bernanke, ``It looks to be a very orderly and moderate kind of cooling at this point.” In addition, you have Former Fed Chair Alan Greenspan echoing the same concerns that ``housing boom is over”, although noting that there is ``no evidence home prices are going to collapse.''

Of course, would it be sensible for present or past officials to prognosticate for a “collapse” as to likely trigger a financial panic? The answer is quite obvious. Yet given the law of unintended consequences, what the financial markets could be telling us at present is something we don’t naturally want to hear....a possible risk of a BUST!

The performance of the housing market in the US has manifested of a strong correlation to the consumer spending dynamics as shown in Figure 2.

Figure 2: courtesy of John Maudlin/ BCA Research: Falling Housing and real consumer spending?

What these officials could be implying is that given the close correlation of the housing dynamics to consumer spending, the backbone of the US economy, these means that consumer spending will also backtrack (and so with Asia’s and the emerging market’s export led growth) and that the US economy would see a marked deceleration soon; as to the extent or degree of the slowdown is something that has yet to be seen.

Some analysts including the widely respected BCA Research tells us that another liquidity propelled rally, due to a possible pause by the US FED on its march to normalize interest rates, could ensue on the premise of low inflation data from the major world economies belonging to the OECD, an attendant retreat in inflation in the US due to its expected growth slowdown and possible rally in global bonds in anticipation of a slowdown of global growth. This perspective is quite convergent to the projections of Deutsche Bank which I presented last week (see Deutsche Bank: Fed’s Monetary Approaches Equals Different Outcomes).

However in stark contrast, John P. Hussman, Ph.D. of the Hussman funds argue against such rose colored glass expectations (emphasis mine), ``It doesn't help to argue that the Fed will stop tightening soon, because the end of a tightening cycle has historically been followed by below-average returns for about 18 months.”

Yet, all these polemics come in the perspective of the possibility a Fed pause. However, during the Federal Open Market Committee Meeting last May 10, its minutes manifested discussions of the possibilities of even raising by 50 basis points!!! Which means while the apparent consensus have been looking for a pause, incidental probabilities dictate that a 50 basis points increase could be the axiomatic “elephant in the room”!

Now the question remains, will the Fed take its pause or will it raise rates to “quell inflation” or in camouflage, defend the embattled US dollar (my long held view)? If the latter, by how much?

Falling US Dollar Leads to Stagflation?

Figure 3 Discordant Signals Falling US dollar Falling US Treasury yields (courtesy of stockcharts.com)

A falling currency is seen as “stimulative” and “inflationary”, yet as of last week, the US dollar trade weighted index appears to be rolling over, as seen in Figure 3, apparently looking towards a test to its recently marked lows (emitting inflationary signals). On the other hand, US Treasury 10 year benchmark yields (black line) appear to have broken down from its peak, signifying either a “sharp slowdown in inflationary expectations” and or an “economic growth slowdown” or both.

Figure 4 US Dollar Index St Louis Model Breaks down! (courtesy of contraryinvestor.com)

The St. Louis Federal Reserve’s methodology in computing for its US dollar trade weighted index is more representative of the country’s trading patterns than the New York’s Board of Trade (NYBOT) model, according to contraryinvestors.com (emphasis mine)...

``The bottom line is that approximately 2/3rd's of the US Dollar Index is keyed off of Euro area currencies. And unbelievably enough, the USD Index does not contain any relative currency weighting at all to key trading partners such as Mexico and many Asian countries such as Korea, Thailand, Taiwan, Singapore, Hong Kong, etc. It just so happens that the St. Louis Fed does calculate an alternative trade weighted dollar index that is much more representative of the true US trade situation globally, importantly inclusive of Mexico, China and many Asian currencies...Unlike the widely quoted, largely Euro area currency driven US Dollar Index, the St. Louis trade weighted dollar index has now broken below the late 2004 and early 2005 lows. It's telling us that it's a good bet the headline US Dollar Index follows. If indeed this comes to pass, we have to believe the consensus will be taken a bit aback in terms of heightened inflationary concerns.”

If contraryinvestor.com is right about their projections of a continued downdraft of the US dollar then what may strike as the UNSEEN variable could be a “stagflationary” environment, or characterized by low/stagnant growth and high inflation (a scenario we discussed since 2003)!

The Curtailment of the Yen Carry Trade: Getting A Larger Audience

Second, is that the backstop of the synchronized global rate hikes has possibly prompted for the retrenchment of the Yen Carry trade arbitrage.

I noted that the economic recovery prospects in Japan has reduced its need to flood its banking system with excess cash/reserves and thereby go about restoring normalcy to its monetary policies by lifting its easy money policies such as the QE Quantitative Easing and eventually the ZIRP Zero Interest Rate Policies (see last week’s Jim Jubak/Gavekal: Yen Carry Tumult and Apr 24 to 28 edition, Improving Your Portfolio Returns by Seeing the Unseen).

Where global investors used to lever funds from an almost zero interest yielding yen to arbitrage investments in diverse asset classes, such as US treasuries, emerging market debts and or equities or even commodities, the prospects of normalizing Japan’s monetary policy effectively lowers the economic incentive to straddle between the yield differentials between currencies, where the arbitrage opportunity lies.

It has been widely suspected that the recent selloffs in the global financial markets had been linked to the liquidity crunch or deleveraging brought about by Japan’s move to tighten its money policies. ``The unwinding of yen-carry trades exacerbated sell-offs that started with a slide in the U.S. dollar and falling commodity prices.” notes Bloomberg Asian analyst William Pesek Jr.

Mr. Pesek further observes that ``What makes the yen-carry trade so worrisome -- and easy to dismiss as a potential problem for markets -- is that no one really knows how big it is. It's not like the BOJ has credible intelligence on how many companies, hedge funds or mutual funds borrowed in yen -- or how much -- and put the money into assets elsewhere.”

Well, Gavekal Research whom has done a persnickety work tracking down yen capital flows has estimated that about US$1.8 trillion worth of Japanese capital found its way into the global financial markets in sundry assets, mostly to US treasuries. This is equivalent to around 15% of US GDP or 3% of US assets.

In other words, with the previous massive capital outflow from Japan’s residents plus a heavily yen denominated leveraged global financial community, any drastic moves to imbue or absorb back excess reserves or raise rates could further unsettle and destabilize the global financial markets.

With the Japanese governments’ apparent acknowledgement of the global market’s fallout, which had been “aggravated” from its pronounced reversal from its present “anti-deflation” policies, it has pumped back a record 1.5 trillion yen into the money markets last May 29th. This action suggests that Japan’s government, cognizant of the probable negative repercussions posed to the global financial markets, may go slow in its attempt to restore normalcy with its monetary policies.

This simply shows that the world markets will have to adjust and learn to live with the newfangled risk environment posed by Japan’s recovery, in the mellifluous words of Bloomberg’s Mr. Pesek, ``The world has anxiously awaited Japan's recovery, and its arrival is good news for Asia. Yet there's a catch: As Japan raises its interest rates, it may export higher borrowing costs everywhere else.”

Until then, the likelihood is that markets would remain volatile while it adjusts to present realities.

Philippine Assets: Vulnerable to Liquidity Crunch

What has all these got to do with Philippine financial markets? Almost everything.

For the Phisix, which has been predominantly backstopped by foreign buying since 2003, question is how much of these portfolio investments have been levered to the Yen carry arbitrage or through various channels intermediated by the hedge fund dominated highly sophisticated leveraged/credit system.

The massive conflated sellout in almost the entire spectrum of asset classes simply validates my analysis that today’s markets have been largely macro driven brought about by the technology enabled financial market integration and increased globalization.

Figure 5: stockcharts.com Phisix and JP Morgan Fleming Emerging Markets

Once a similitude of a liquidity crunch occurs, as in the recent case, our asset class despite being a nominal laggard compared to its neighbors or its peers, would likely reflect the same degree of activity but of a more subdued intensity. As an illustration, the Phisix in red candlestick closely tracking (peaks and troughs-have been almost as one) the movements of the JP Morgan Emerging Market Index...

Need I say more?

Figure 6: IMF Growing Domestic Investor Holdership of RoPs (%)

And of the bond markets, despite the improving percentage of ownership of RoPs by domestic investors ($10 billion), mostly by banks (81%), insurance and pension companies (14%), foreign money still dominates ownership of the $28 billion outstanding, according to the IMF. Given the above, the likelihood is that the dynamics in the bond markets despite its fundamental differences may somewhat reflect that of the Phisix.

Understanding Math of Expectations Differentiates Gambling from Calculated play

``Think of how stupid the average person is, and realize half of them are stupider than that.” George Carlin, US Comedian and Actor

Last week, I’d been posed a wily question at my blogsite on whether, given my present outlook, what constitutes a calculated play and a gamble?

I’d like to share to you my response. We are living in a statistical world of frequencies and probabilities such that the impacts or effects of our choices could be actually be measured by certain available variables during the time of reckoning. This is known as the concept of the mean (also called average or expectations).

Because of the complexity of the structural makeup of the financial markets, in most circumstances the profusion of variables could lead a participant to overlook certain variables or to overemphasize on some, given one’s innate biases. And this leads to what we may call as asymmetry.

In the financial playing field there is what you call an asymmetry of odds and the asymmetry of outcomes. Asymmetry in odds suggests that the distribution of probabilities is not a level 50-50% but with one aspect of the probability higher or greater than the other, while asymmetric outcomes mean that the payoffs are not the equal.

Let me ‘frame’ you a case which I lifted from mathematician Nicolas Taleb ``Fooled by Randomness”...

``Assume I engage in a gambling strategy that has 999 chances in 1,000 of making $1 (event A) and 1 chance in 1,000 of losing $10,000 (event B).

Event Probability Outcome Expectation

A 999/1000 $1 $.999

B 1/1000 -$10,000 -$10

Total -9.001

``My expectation is a loss of close to $9 (obtained by multiplying the probabilities by the corresponding outcomes). The frequency or probability of the loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome. Odds are that we would make money by betting for event A, but it is not a good idea to do so."

What Mr. Taleb suggests is that most people (including those with advanced degrees or MBAs) would be enticed to act on the winning odds (Event A) due to the inordinate focus on the frequency despite the understanding that an occurrence of a low probability event may affect a greater deal relative to the outcome than the combined wins. This blatant omission, despite the mathematical fact, is likely to lead to the decimation of one’s portfolio.

In other words, the difference between a calculated play and a gamble is matter of understanding the ‘concept of mean’ or of knowing one’s profit or loss expectations arising from the mathematical computation of events as determined by its probabilities and its potential outcome.

Edward Lefévre who wrote on behalf of legendary trader Jesse Livermore, in Reminiscences of A Stock Operator, notes of the importance of understanding probabilities even as a trader, quoting Mr. Lefévre at length,

``Observation, experience, memory and mathematics—these are what the successful trader must depend on. He must not only observe accurately but remember at all times what he has observed. He cannot bet on the unreasonable or on the unexpected, however strong his personal convictions may be about man’s unreasonableness or however certain he may feel that the unexpected happens frequently. He must bet always on probabilities—that is, try to anticipate them. Years of practice at the game, of constant study, of always remembering, enable the trader to act on an instant when the unexpected happens as well as when the expected comes to pass.”

Applied to the present risk environment, this is where, in my view, the probabilities of an outsized returns are greatly less than the potential losses until mitigating signs say otherwise.

Walking On A Thin Line

OVER the short term, developments in the global and domestic financial markets have fallen squarely to what I have projected for it; particularly of the continuation of the violent shakeout as well as some signs of an intuitive countertrend reaction or of a rebound.

During the last two weeks the Philippine benchmark or the Phisix has lost about 217 points or about a considerable 8.66%, while one may argue that recent events may signify signs a “typical profit-taking” in the eyes of the rabid optimist, the degree and intensity of the recent selling has not been your average “profit taking” but one of the extremes or found most commonly during the bear market cycles or the declining phase of a stock market cycle.

And as mentioned in our previous outlook, the gamut of events has been a globally coordinated one such that the recent selloffs have been seen across the wide spectrum of asset classes.

Just to give you an example, Bloomberg’s Michael Tsang reports that the some of the world’s best performing bourses as Russia and India were compelled to undergo a trading halt to forestall the massive declines, ``Russia and India, among the best-performing markets in the past year, have fared even worse. The Russian Trading System Index has slumped 20 percent since reaching a record on May 6, trimming its gain for the past 12 months to 110 percent. India's Sensitive Index has lost 14 percent of its market value since closing at its highest ever level on May 10. The measure surged 65 percent in the past year.

“On May 23, exchanges in Russia and India halted trading for an hour as prices plunged, while the Micex Stock Exchange in Moscow closed 15 minutes early. The declines helped send the MSCI Emerging Markets Index to its biggest loss in two years.”

Figure 1: Price movements in Russia’s Moscow Times and India’s Sensex (Bloomberg)

Of course, nothing beats visualization. As Figure 1 show, the Russia and India’s recent meltdown after coming off its liquidity-driven heights.

Figure 2: MSCI Emerging Free Index and Phisix

Figure 2 Morgan Stanley’s emerging market index (red line) falling to its critical support level (blue horizontal line) while the Phisix (black line) likewise bouncing off support levels (red horizontal line).

What I am trying to say is that the accentuated gyrations or dislocations have led major financial market bellwethers drifting near sensitive threshold levels. Albeit, present signs of relief, as shown above and below (US Dow Jones), indicate that instead of outright submission or simply falling apart, the bulls appears to have regained some momentum to counteract on the bearish uprising.

Figure 3 Dow Jones Holding Off

And this consolidation or signs of ‘indecision’ have remained so, as similarly evident in the bond and currency markets.

Despite slight indications of amelioration, my outlook has basically remained the same; considering that the risk environment remains high relative to returns, potentials of higher cost of money relative to prospective returns (19 central banks raising rates including the Bank of Canada) and more fools than money making opportunities, makes me extremely cautious and risk averse at the moment.

Nevertheless, the recent rebound could imply that one or two trading sessions does not a trend make or in parallel terms, that the latest volatility could even be an anomaly to the general upside trend. Until we see further concrete signs of stability I’d remain generally underweight unless specific “trading” opportunities arise.

Deutsche Bank: Fed’s Monetary Approaches Equals Different Outcomes

I recently argued that instead of the conventional inflation bogey bandied around by mainstream media, a possible global economic growth slowdown spurred by the US (transmitted via slowdown in US real estate industry), derivative based liquidity withdrawal or possibly a contagion arising from hedge fund losses cutting out margin positions as possible culprits to the recent shakeout.

Deutsche Bank's Asian Macro Strategy (lifted from Fullermoney.com) seems to somewhat echo on my views (emphasis mine)...

``Our macro risk model sees this sell-off as a consequence of a deteriorating global growth/liquidity environment. However, the model is not short because our growth/liquidity overlay is not yet signaling sufficiently weak growth to trigger a short;

``However, the growth/liquidity overlay is deteriorating rapidly - so rapidly, in fact, that there is a strong likelihood we shall enter a new business cycle phase within a matter of weeks or even days;

``In this next phase - which we dub the early slowdown phase - markets reverse the way they react to growth. Weak growth switches from being a negative to a positive. We typically see an aggressive short squeeze and a final blow-off rally in this phase. This happens because markets come to accept that growth is slowing but find encouragement in the "promise" of potential Fed easing;

``Assuming we do enter this phase, we expect to see the markets consolidate above critical support and rally into the August/September timeframe;

``Please note, however, that our macro model sees significant risk that a bear market will eventually unfold if the growth deterioration persists. The risk of an eventual bear market becomes more pronounced if the Fed embarks upon further rate hikes. Our model suggests a Fed funds rate of 5.75% would be sufficient to bring on a bear market;

The anticipations for a FED easing have been floated for most of the second part of the early semester of the year and have led to a liquidity driven rally spread throughout the various assets throughout the world until the past two weeks. While Deutsche Bank sees a growth slowdown as the common denominator on the risk side, the countervailing repercussions arising from “expectations” of a possible Fed easing (a relief rally from short covering) or from further hikes (an unraveling bear market). In both instances, the risk factors appear to be “weighted” than prospective returns.

Merrill Lynch: Dead Cat’s bounce on Bullish Outlook

Merrill Lynch’s Emerging Market Outlook (Outflows = Lows) also lifted from fullermoney.com equally stresses on the emerging risk prospects but at a much ‘subdued’ level (emphasis mine),

``Inflows have ceased and modest redemptions have begun. According to EMPortfolio.com, EM equities have just had one of their worst weeks for fund flows this year. Inflows slowed to just $43 million (compared with weekly average of +$1.6 billion) and investors pulled money from both GEM and EMEA funds in the week to May 17th.

``Leveraged funds have shifted decisively from long to short and global equity mandates have reduced their emerging market exposure considerably. High daily levels of volumes indicate that non-dedicated investors have moved quickly to greatly reduce exposure. Less "greed" is a good thing. But investor positioning does not yet suggest that a quick return to the EM bull market is plausible. Sentiment is not "irrationally pessimistic" and the "buy-on-dip" spirit has not been broken, in our view. Moreover, we are yet to see the massive fund outflows which normally signal a decisive market low. The May meltdown best mirrors the 21% sell-off in EM in April/May 2004, both in terms of speed, magnitude (see Chart 4) and causation (risk aversion, rate tightening fears, EM FX and debt markets in a spin and so on)...

``So while we do not see the inflation or the U.S. dollar collapse to predict the bull market is over, our reading of investor positioning and sentiment today argues that a modest dead cat bounce is the best we can hope for in coming weeks (as was the case in 2004).

In other words, the recovery prospects recovery on the emerging market class as described by Merrill Lynch is likely to be one caution or “U-shaped” recovery rather than of an abrupt one (“V-shaped”).

BCA Research Hedge Emerging Market by Shorting Metals

BCA Research, on the other hand recommends emerging market investors to “hedge” their portfolios via taking on “short” position on metals instead of liquidations...

Figure 4 Emerging Market vs. CRB Metals

``We are still positive on EM stocks over the long haul, but the near-term turbulence could persist. A possible strategy to reduce risk for EM equity investors is to go short the CRB metals index as a hedge. EM stocks closely track the industrial metals index, due to the sensitivity of both to global growth. However, the gains in metals have outpaced EM equities by about 25% this year. In addition, there seems to be a well-defined cycle in EM equity relative performance against the metals index. The sharp drop in the ratio of the two indexes appears to have set the stage for a reversal, leading to a period of metals underperformance.”

BCA remains largely bearish on copper over the near term on the outlook of possible weakness from the demand story out of China.

Jim Jubak: Yen Carry Tumult

And there is also the Yen Carry trade factor previously discussed in my Apr 24 to 28, edition, (see Improving Your Portfolio Returns by Seeing the Unseen), where I mentioned that Japan’s monetary base has been bloated by its government to “reflate” the economy (even larger than the US), whose monetary policies (Quantitative Easing ‘QE’ and ‘ZIRP’ Zero Interest Policy) has led to massive exports of capital outside Japan to the tune of $1.8 trillion(!!!) or something like 15% of US GDP or 3% of US assets.

According to Jim Jubak MSN Money editor, writing for thestreet.com “How Japan Sank the US, (emphasis mine),

``Now that the economy is finally growing again and now that prices aren't sinking any longer, the Bank of Japan has given two cheers to the return of inflation and has started to remove some of that cash from the financial markets.

``In the last two months, the bank has taken almost 16 trillion yen, or about $140 billion, in cash deposits out of the country's banks. The country's money supply has fallen by almost 10%. The Bank of Japan isn't finished pumping out the liquidity that it had pumped in. That should take a few more months. And when it is finished, the Bank of Japan is expected to start raising short-term interest rates.

``The moves to date by the Bank of Japan aren't enough to radically diminish global liquidity, but they are enough so that the investors who have fed some of the world's riskier markets understand that the trend has turned.

In other words, some of the massive amount of leverage employed using the Japanese Yen as source funding for the hunt of yields across global assets could have been recently curtailed by the rising prospects of Japan to “normalize” its monetary policy.

In effect, Japan’s turn to tighten its monetary screws could have possibly let off a wave of destabilizing domino of deleveraging off the world’s financial markets!

Trader George Kleinman: Bullish Gold Prospects

Finally, one sanguine outlook comes from veteran commodities trader, Mr. George Kleinman. The impetus of the recent corrections in Gold has mostly been due to the unwinding of open interest defined by cme.com as the ``Total number of futures or options on futures contracts that have not yet been offset or fulfilled for delivery.”

As shown in Figure 5, while Gold had been reaching fresh 25 year record highs in mid May, open interest diverged with its underlying prices (blocked arrow bottom window) reflecting that “smart money” had been liquidating while weaker hands had been taking over.

Figure 5 Gold and Open interest courtesy of George Kleinman

On the other hand, the present decline in Open Interest is a possible sign that weak shorts have been bailing out.

Mr. Kleinman observes,

``OI is now down to approximately November 2005 level, around the same point where gold broke above $500 for the first time in more than 20 years. That began a $200-per-ounce bull run. This is potentially very bullish for the gold market.

``Here’s another way to look at it: When the last of the weak longs has liquidated (and the last of the strong shorts--the “smart money”--have covered their profitable short positions), there’s a lot of room for gold prices to move back up. The next bull run will unfold as OI is being built back up.

``As soon as OI and the per-ounce price start to rise again in unison, I look for the next leg up to begin. I think we’re very close to a major new buying opportunity in the gold market. The last leg took gold up about $200 ounce, from about $530 to about $730. Assuming $636 turns out to be the bottom, a similar up move would take gold to more than $800.”

And what has this “Gold” got to do with emerging markets? Figure 6 courtesy of stockcharts.com gives away the correlation so far between gold and the MSCI Emerging Free during the past three years. A correlation is a correlation until it isn’t.

Figure 6 Stockcharts.com: Gold vis-à-vis Emerging Markets

In essence, while today’s global financial markets reveal of heightened risks as detailed by the richly diverse outlooks of the distinguished institutions and personalities mentioned above, there are possible divergences in assets that may unveil itself in the fullness of time.

If indeed Gold, as a barometer given its present strong correlations between the performance of emerging assets and the monetary metal, could be seem to bottom out in the interim, the odds are that emerging markets could follow suit and may outperform anew as Gold seeks new highs in spite of the present uncertainties. It all boils down to alternative investments or fleeing from paper based assets.

In the invaluable words of the prescient commodity oracle, Mr. Jim Rogers, ``During a time when many of the world’s largest economies were in recession in the 1970s, oil prices increased several fold. The UK went bankrupt during that period and had to be baled out by the IMF. But oil and commodity prices boomed. Another major boom in commodities started during the depths of the Great Depression, in 1933. That was arguably the worst collapse in global demand in history. Global trade fell more than 50%, yet that was the start of a long commodities boom.”

I have been patiently waiting for such a divergence to meaningfully unfold.

Mises.org: Morgan Poliquin: "Sustainable Development" Privileges the Few

From Mises.org: "Sustainable Development" Privileges the Few
by Morgan J. Poliquin

Nomenclature and in particular, catchy phrases and slogans, are integral to the institution and leadership of political action and violence as well as simplifying or condensing the rational for such action into neat and all encompassing phraseology.

Take for example, "from each according to ability, to each according to need." This trite phrase uttered by Bolsheviks encapsulated the raison d'être and legitimized the terror inflicted by their foot soldiers against "bloodsuckers" and "enemies of the state" who were murdered and relieved of their property. Who was a bloodsucker or enemy of the state was decided upon by Bolshevik leadership.

In other words, the state, which manifests itself in the form of certain individuals supposedly acting on behalf of everyone, will determine what peoples' abilities and needs are. The problem with forcefully organizing society in this way is that every human is different, possessing unique abilities and needs according not to what someone in a position of power has allotted them, but to their own sensibilities.

Not only is force to achieve these ends immoral, but it is impractical and wealth-destructive. We all condemn slavery, so why is it not immoral to force people to act in a way that is deemed to be beneficial to them?

In 1987 a new but eerily similar political term was coined — "sustainable development" — which is defined as follows:

Development that meets the needs of the present without compromising the ability of future generations to meet their own needs.

This definition is attributed to Dr. Gro Harlem Brundtland, a medical doctor and the former Prime Minister of Norway, who, at the bequest of the then Secretary General of the United Nations, established and chaired the World Commission on Environment and Development. Her Committee produced a report entitled Our Common Future in which the definition first appeared.

Subsequent to the publication of the report, an enormous amount of meetings have been carried out, largely attended by state officials, state-financed intellectuals and the management of large corporations, to discuss the implications of such a statement and in particular its implementation in the form of coercive state regulations, which are coming into effect worldwide.

These regulations are far-reaching and designed to increasingly impact people's everyday decision making.

The private sector has been forced to swallow this new pill whole and almost without question. Companies are anxious to demonstrate how their practices are sustainable in order to curry favor with regulators.

This rush to compliance is all too reminiscent of the Y2K fiasco when every company and organization was required, by law, to devote significant resources to demonstrating that they were Y2K compliant.

Coercive communism is a failure because it consists of a self-appointed elite forcing needs and abilities upon people against their will. Needs and abilities cannot be determined arbitrarily by leaders; they stem from each person according to their own unique value system.

Similarly, "enlightened" leaders should not be able to force us to act according to their assessment of what future generations' needs may be. Yet this is precisely what they propose.

Apart from the immorality of such an imposition, it doesn't even make sense practically. This is no more apparent than in one of the most integral of activities to industrial and modern society: mining. Anything we utilize has either been grown or mined. The most useful, sturdy and long lasting of things, such as concrete, steel and copper wire, are made from material that is mined.

Metals are not naturally occurring in forms that are readily useful; formulae derived from experience and labor are required to produce metal in a useable form. The cost and effort to extract and refine elements such as iron and copper are so high that metal has always been recycled which is possible because the properties of metals are not lessened by nature over time, unlike wood and other "farmed" substances.

The Bible speaks of turning swords into plowshares and that is what even industrial societies do today. For example, roughly 50% of all copper "consumed" in the United States is recycled. There are no government mandates that force this on people, it is just good sense on account of the fact that it is cheaper to melt a metal item and remake something new with it than to search for a new copper mine, develop it, dig out the copper, refine it and then make the new item.

In this very real sense, mining is infinitely sustainable; the needs of future generations will be met over and over again by the metal that past generations have found, extracted and refined. Before the metal was found, extracted, and mined, it was useless to humankind and there was nothing to even evaluate as sustainable. The fact that the metal has been removed from the ground and no longer exists there is not a sign of non-sustainability; rather it has created a permanent and unending supply of copper that can be recycled and reused ad infinitum.

Legislating sustainability is another attempt to replace the collective decisions of many in the market place with the coercive will of the few. In a free market, with increasing scarcity of a given resource, its price tends to rise, encouraging economizing on behalf of those who consume the resource.

Why then all the fuss about making industries such as mining sustainable? Perhaps the people behind the legislation — the intellectuals, the legislators, and the large business firms that already dominate their industries — form an alliance that serves their own self-interests. The revered intellectuals sit on endless committees defining meaningless terms like sustainable development and are paid handsomely for doing so.

They are also lauded, much like actors, by their own organizations, which continually self-produce awards. Mingling with media, wealthy patrons, government officials, and business leaders, they frequent the most exclusive locations on the planet to discuss the implementation of their leadership. The self-interest of the legislators and government is readily apparent as their incomes are derived from the taxes that society is required to pay, purportedly for their management of the new laws and regulation that will ensure sustainable development.

Established business firms would like to prevent others from offering similar services to those they provide. As Dr. Gabriel Kolko pointed out in his Triumph of Conservatism, the rise of government regulation in the 1900s in the United States resulted directly from the appeal for its implementation by established businesses.

Regulation, far from being established by altruistic intellectuals and far-sighted politicians, creates government-enforced cartels for (and was conceived by) the established businesses that were losing their command of the marketplace to new business that were providing cheaper and better products and services.

The regulation favored the large, established firms. The implementation of sustainable practices is condoned, supported, lauded, and financed by the big businesses of today. Like their 19th-century counterparts, they have the accounting staff and present infrastructure to handle the extra costs of becoming "sustainable." It is the little guy — the new entrepreneur — who is paralyzed by the burden of the new legislation.

The enlightened intellectuals behind sustainability today are likely dupes who are happy to exchange accolades, notoriety, and large UN salaries for creating nonsensical legislation that only serves to inhibit new enterprise and entrench established business interests.

Who is hurt by this? Certainly anybody who would like to enter a new business into the marketplace, but more importantly it is the consumers of the products these industries produce who are harmed. Coercive legislation reduces the diversity of quality and prices among competing products. It robs consumers of options, raises prices, and destroys wealth.

Nobody can decide what is "sustainable" for another person. Every action requires a weighing up of costs and benefits. To implement any one person's idea of sustainability on everyone else will result in loss. The idea that people are not able to make these decisions on their own, and require leadership and coercive laws to determine what is best for them, is essentially to implement slavery.

Communists told us to follow them because humanity was at stake. Today we are told that the planet itself is at stake. It sounds like a new way of saying the same old thing. To sacrifice the needs of individuals for the sake of the many will result in great benefits to the very few, at the cost of the many.

---

Morgan Poliquin is a registered professional Geological Engineer, holds a Masters degree in Geology, and manages a publicly traded exploration company.

PERC: PLAY COULD BE OVER!

One of the amazing feats during the recent run up has been the rush of adrenalin by Petroenergy Resources . The small company has a market capital presently of about P 1.9 billion (as of May 19^th) which jumped from only about P 500 million in the 22 sessions past. It has been the only oil revenue generating publicly listed exploration company in the Phisix. While other oil exploration companies have sizeable contract rights over prospective domestic oil fields, PERC’s revenues emanates from its partnership with Vaalco Energy Inc., at a large prolific offshore project site in Gabon, West Africa.

PERC’s story is practically an embodiment of the quintessential investing mindset of local investors; with a knack of speculations and devoid of fundamentals.

Since its peak during the initial run, prompted by a dividend play, sometime middle of last year, PERC’s share prices remained stuck in inertia, even despite its pronouncements that it had doubled its earnings as early as the third quarter! Investors were basically unmoved by such an earnings surprise!

Further, its operating partner Vaalco Energy declared a 28% rise in diluted earnings for 2005 as early as March 9^th of this year, yet the market appeared to have ignored such pleasant positive unexpected news while PERC’s share prices continued to languish even as its oil peers Oriental Petroleum and Philippine Overseas made substantial advances due to a bullish general sentiment...until of course, April 18^th.

PERC: Technically still overbought

On the 19^th of April, PERC’s prices suddenly caught fire and trailblazed upwards for about 22 days until Friday May 19^th where it closed at 16.75.

The move caught me by surprise since it leapt from about P 4 to over P 19 with apparently no logical explanation for such stellar performance.

I had initially thought of another dividend play at work, but for an advance of over 300% looks something immensely more than what it seemed.

Then came thoughts of a possible new oil reserve find or an activation/speculation of its oil drilling project/s locally. Yet, the market remained as animated and heaped by persistent speculations with no news to back it up.

I attended Thursday’s investor’s briefing precisely to find out the reason for its recent explosion only to be disappointed. What has been said in the presentation, aside from the financial updates, was basically the same as what it had reported last September.

Then came Friday morning’s news disclosure. The company announced that its chairman Delfin Lazaro sold his 1,000,000 shares on the March 16^th and 17^th alongside with colleague Director Cesar Buenaventura and company president Milagros Reyes.

At the end of the trading day Friday, the company likewise disclosed that Monte Oro acquired 10,015,098 shares which represented 9.51% of the company’s outstanding stock! This had to be it! From April 19 to Friday’s close, total shares traded was a little over 65 million shares! This meant that about 15% of the accrued activities during these days had been due to Monte Oro’s acquisition at the board!

Without such substantial acquisition activities there would not have been a big advance, not earnings not dividends, as previously shown have driven its share prices but a serious investor willing to accumulate at market prices!

With the completion of the buy-in plus the unloading of insiders, it certainly looks likely that the play is over!

What remain for the company would be the dividends it may likely declare, considering the huge windfall arising from the sizeable spike in oil prices. However, the impressive advance of its share prices has made this more or less moot.

I remain bullish over this company, which allowed me to score a homerun for a second time, but would acquire back its shares when the public has dispensed of its speculative interest.

Besides, I foresee a major oil find by the consortium given the bright potentials of its fertile oil fields.