Dis-Inflation Inflation?

BCA Research observes a similar Broadening of Global Equity Rally, ``Our breadth measure for 36 major country markets has rebounded sharply in recent weeks, indicating that there is increasing participation in the equity rally. This reflects growing optimism that the U.S. economy will enjoy a soft landing and that inflationary pressures will diminish, (emphasis mine) judgments we concur with. Still, although breadth is improving, more growth-sensitive markets, industries and stocks are lagging as global economic growth moderates.” The same spin we heard last week...soft landing and lower inflation.

Figure 5 Economagic: CRB Futures vs. CRB Spot

As I’ve always noted: perspective is a matter of choice or from the lens one chooses to use. As authorities from the US Federal Reserve continue to argue of “risks of inflation” (as per St. Louis Fed William Poole and Chicago Fed Michael Moskow) the market adamantly sees it otherwise.

The apparent dissonance can likewise be seen in the patently contrasting behavior of the commodities market. Yes, we have noted of falling commodity prices lately, which has been used by the Panglossians on the premise of “lower inflation” for continued cheerleading, however this viewpoint emanates from the FUTURES market, whereas in the SPOT market, the CRB commodity index has climbed to new highs (Figure 5) for a radical departure!

According to Ivan D. Martchev editor for Global Viewpoints, ``But this looks to be the largest divergence between the two since this particular spot index was introduced. They’ve tended to move in the same direction. This makes no sense if you believe the “inflation is coming down--fast” scenario. Perhaps margin calls on futures positions have created an illusion of lack of inflation.” As an aside, whereas some commodities have been down, others have been breaking new records such as Lead, Wheat (10-year high!), Corn (strongest week in 18 years!), Nickel (19-year high!) and Orange Juice (16-year high!). As a reminder, inflation manifestations do not come equally. They get to be revealed in different channels.

As I’ve previously said, today’s markets have been all about inflation (too much money and credit chasing too few investments) with apparent disregard to valuations. Markets believe what they want to believe, they have marked inflation as simply oil, or gold and some other commodities instead of its monetary origination. They hanker for “low” inflation to justify “more inflation” (through higher asset prices).

Revered fund manager John Hussman calls it the “Scarcity mentality”, where people ``magnify trivial differences when the stakes themselves are trivial.” Relative to the investing world, where returns have been trivial (diminishing returns) as the flood of money and credit have been used to bid up even illiquid assets around the world, where over 8,000 hedge funds with over $1.2 trillion dollars in managed funds have employed basically the same investment strategies (herding), all for the sake of generating higher returns or the Fund manager’s “Alpha”, more leverage or credit provision is needed. And this required “leverage” could only function under a loose or highly liquid monetary setting or the so-called “low inflation” environment sought after by such market participants. Needless to say, more leverage translates to higher degree of risks (tail/sigma risks-low probability high impact).

Mr. Raghuram G. Rajan, Economic Counselor and Director of Research of the International Monetary Fund identifies the breadth of such risks in his recent speech (emphasis mine), ``Indeed, I do think the greater concern has to be about the rest of the financial system, the 80 percent of value added by the financial sector that is outside the banking system. The non-bank sector is increasingly central to economic activity and is not just a passive holder of assets. Moreover, some non-banks such as insurance companies and some hedge funds are subject to runs.” So essentially non banks have been important sources of liquidity generation as previously argued.

Figure6 Moneyandmarkets.com: Crowded Trade

When we tackle upon risks we equally note of the ongoing market sentiments influenced by the highly leveraged system. Figure6 shows you that the market consensus or has bet heavily into the soft landing-low inflation scenario. According to Mike Larson of Moneyandmarkets.com (emphasize mine), ``It shows trading activity in 10-year Treasury note futures among large speculators. These are the hot money players using leveraged bets to try to make big profits from relatively small bond market moves. In the week ended October 3, a lot more money was betting that 10-year bond prices would rise. These speculators were holding 520,871 contracts more than the people betting against bond prices. Not only was this difference up 9.5% from a week earlier, it was also the single highest level in recorded history — almost twice the previous record from last March.”

Two important observations here: one, big profits from small moves by leverage bets, which again underpin our inflation-leverage standpoint (discussed above) and second, speculators have taken in a one-way or crowded bet; when everyone piles on the same theme, a large probability of a reversal becomes imminent especially when these bets have been anchored upon leverage.

Phisix Supported by Local Buying Amidst A Rising Peso

What has this all to do with the Phisix? Well, as previously defined, our benchmark has followed closely the movements of world markets and of the US.

While we may have underperformed this week (slightly down .12%) as a result of a big chunk of foreign money outflows, local buying appeared to have cushioned the profit taking activities by overseas investors, which makes the activities in the Phisix equally remarkable.

Moreover, in the broadmarket, local buying boosted number of advancing issues relative to declining issues, suggesting that local investors have been unusually optimistic last week, perhaps impelled by the strong advances of the Peso.

Again relative to yield considerations, the prospects of higher Peso yield premiums relative to the US dollar alternatives (the popular option among local investors) and the trend of appreciating peso could continue to boost local investors back into the fold of the domestic markets (stocks, bonds, money market instruments & real estate). Remember, local investors make up a minute segment of the population (penetration level-especially relative to the PSE), and is the key reason why our markets have been relatively underdeveloped and a perennial laggard.

This lack of trust has been one reason why our investments have not picked up. Because cost of financing business ventures using the traditional channels have been high aside from the rigorous requirements needed and the aversion of banks to lend considering the past cycle borne out of the Asian Financial crisis, while, on the other hand, savings and capital reallocation have been inefficiently stashed away on mostly US dollar assets (capital flight).

Instead of trusting the markets, we stubbornly insist on trusting politicians who like most of their ilk around the world are of the “know-it-all-type of improvers”, cut from the same cloth, i.e. the desire for more power and privileges, more spending Other Peoples Money in the name of Social Welfare “Common Good”, and more policies directed to special interest groups (translation-either borrow or inflate the peso and/or sell our gold hoard-yes we’ve been net sellers according to the World Gold Council), thereby remain obstinate adherents of the regressive John Hussman’s “Scarcity Mentality” version applied to the field of domestic politics or my so-called Personality-Based Politics (PBP). A shift in the savings of local residents back to local asset classes would be a big boost to the Phisix, capital formation and the domestic economy.

I made my stand last week, enunciating that perhaps this bullish cycle could last until at least the US November elections, given some signs of possible US election related “Unseen” fingerprints in some of the key asset markets, aside from other factors as liquidity expectations, seasonal or window dressing or tax variables.

So considering the present state, it would be best to simply position cautiously as the market attempts to move higher or to either buy on dips or on breakouts. Don’t forget to mind your stops. And avoid from imprudently chasing prices. Let me remind you of the Sage of Omaha’s Warren Buffett’s important warning ``The dumbest reason in the world to buy a stock is because it's going up.”

US Trade Deficits: Be Careful of What You Wish For

US trade deficit for August leapt to a record $69.9 billion. This trade deficit borne out of the global vendor financing scheme trade structure has been a very important source of worldwide liquidity, as Asia, OPEC and other Oil and/or Resource exporters continues to subsidize US consumers via recycling their foreign exchange surpluses into US assets mainly into US treasuries.

Figure 7: Elliot Wave Independent: Trade Deficit Beneficial to Markets

While we continue to decry these imbalances as unsustainable and as possible spark to a future financial or economic conflagration, US equity markets appears so far to have been funded by it (see Figure 7).

Allan Hall of Elliott Wave Independent commented, ``In fact, The Elliott Wave Theorist pointed out long ago that the trade deficit was rising with the bull market. Back in 1988, EWT used just the first half of this chart to state, “Based strictly on the chart, people should be rooting for perpetually soaring deficits!”

They predict that since liquidity has been generated by these deficits a contraction or reversal of these deficits will lead to a reversal and possibly cause the stockmarket to decline.

Now that a slowdown is clearly at works in the US economy but whose degree remains argued by the various schools of thought (the soft, hard and no landing camps), these deficits are expected to have peaked out or reached inflection point, as imports are likely to decrease while exports may continue to remain strong due to relative strengths of the ex-US global economy.

Figure 8 Gavekal Research: US Current Account Deficits and Financial Crisis

Like Alan Hall of EWT, Gavekal Research posits a similar view but on a different scale, the keen-eyed analysts says that ``a reduction in the U.S. current account deficit is equivalent to a liquidity squeeze”. And such liquidity squeeze in the past has been associated with financial crisis in some parts of the world such as Japan’s depression, Tequila Crisis, Asian Crisis and Argentina Crisis (see Figure 8).

The difference between the two camps: the Gavekal team presages a similar crisis to erupt in some other parts of the world and expects global money flow back to safe haven markets hence, remains bullish with the US dollar and US and OECD markets (low volatility due to emergence of platform companies) and expects a deflationary BOOM as an outgrowth, while, the EWT camp sees a decline in US and global equities, or deflationary BUST as a result of the unwinding of the credit bubble.

My view: the source of all these imbalances (inequality) has been anchored on the inflationary Dollar standard system. I think the ripple effect following its unwinding would be centrifugal in nature.

As noted earlier, the market consensus has been piling onto US treasuries as a one way bet on the purview that the US economy would slow significantly. Be careful on what you wish for.

Reuters: Online brokerage account scams worry SEC

While online trading is still in an embryonic stage in the Philippine setting, the functional equivalent of “an ounce of prevention is worth a pound of cure” means recognizing risks posed by “Incursion scams” and taking the necessary security measures to prevent from falling victim to these predations. Here is an important excerpts from the Reuters,

``Crooks will load a victim's computer or a public PC with a spy program to monitor a user's activities and capture vital information, such as account numbers and passwords.

``The program then e-mails the stolen information back to the thief, who can use it to open victim accounts.

``Once inside, the thief may sell off an account's portfolio and take the proceeds. Or electronically hijacked accounts may be used for "pump-and-dump" schemes to manipulate stock prices for profit, Ricciardi said.

``Public computers in such places as Internet cafes and hotel rooms are especially vulnerable to incursions. But home computers may also be hit as spyware can be imported simply by opening an e-mail attachment, said John Stark, chief of the SEC's Office of Internet Enforcement...

``Steps to fight incursions include securing an online account by changing passwords frequently and never using an unfamiliar computer to enter an account number or password.”

Are Equity Markets Defying Gravity?

The Dow Jones Industrial Index, one of the key yardsticks for US equities hit milestone record highs last week!

Figure 1: Chartoftheday.com: Record High but needs a Hurdle to clear

Before we proceed further, one would most probably ask; of what significance is the Dow Jones to the Philippine counterpart, the Phisix?

Figure 2: stockcharts.com: Phisix-DJIA Close Correlation

The above picture tells you bluntly that the activities in the Phisix (red candle) have been closely correlated with the developments in the US markets, as represented by the DJIA (black line) for a lengthy timeframe. More pronounced is the almost lockstep movements of both benchmarks from May to the present.

Since the US markets have shown tight correlation with that of the Phisix, it is imperative for us to understand WHY their markets are behaving in such manner, its probable trajectory over the interim as to convey our risk-reward outlook, and importantly our possible tactical approach under the present setup.

Here is what Bloomberg reported during last October 4’s catalytic rise (emphasize mine), ``U.S. stocks rallied the most in seven weeks after the biggest part of the economy slowed and Federal Reserve Chairman Ben S. Bernanke acknowledged a housing slump, encouraging speculation that benchmark interest rates may decline next year...Service industries, accounting for about 90 percent of the economy, expanded in September at the slowest pace in more than three years and a gauge of inflation plunged. Bernanke said a housing slump will lop about a percentage point off economic growth in the second half and limit expansion next year.”

Here are the thoughts of some mainstream analysts in support of the Dow Jones’ landmark accomplishment (emphasize mine):

Dr. Ed Yardeni of Oak Associates, ``I figured stocks might rally strongly over the rest of the year because the Fed was done raising interest rates. Fed officials had accomplished both of their stated goals: (1) They succeeded in taking the "froth" out of housing.... (2) They are succeeding in containing inflation.

Mr. Tobin Smith of Changewave.com, ``Earnings per share at the S&P 500 companies (which represent 87% of the $15 trillion U.S. market cap) are NOT growing at 14% on the operation level. They are at the earnings per share (EPS) level because of stock buybacks. As my ol' buddy Bob Olstein of the Olstein Investment Funds always says, "Growing EPS via stock buybacks is JUST as real as growing EPS from operations." A 14% EPS for S&P growth in a 2.5% growing economy is breathtaking, and it makes the S&P 500 at 13 forward P/E cheap.

``Prices at the gas pump really do have a oversized impact on consumer sentiment... Oil is 25% down from the highs, and $55 to $65 oil is the new, new trading range...There is a GIGANTIC liquidation and redemption sale going on in the energy patch.”

``There is a LOT of money coming back to the good 'ol market from the day traders of the residential housing market -- i.e., the flippers...The next Fed move will be DOWN, not up...A lot of people have missed this rally -- and they want in.”

Let us summarize the latent missives we are getting from the recent rally.

1. A slowdown is good for the market because interest rates WILL go down.

2. Lower Energy Prices are helping CONTAIN INFLATION.

3. Stock buybacks are DRIVING earnings.

4. Money from Housing and Energy or those from the sidelines will SHIFT to Equities.

And all the while you have been made to believe by investing textbooks that stock market investing was about earnings growth, right? Well how does one expect higher earnings or rising dividends on an economic slowdown or a general downturn in the business cycle? This simply defies logical arguments and it certainly beats me.

Lower interest rates or lower price of money would be permissive for investors and speculators to increase on leveraging or borrowing more which in essence translates to MORE inflation! Stock buybacks generally help investors in terms of levitating share prices or keeping share prices afloat but does not increase future cash flows by expanding underlying corporate operations or improve the economy’s capital stock. On the other hand, sectoral rotation simply implies momentum investing where money managers go for “popular themes” in pursuit of short term returns at the expense of disfavored ones.

So based on the above premises, the conventional thoughts on stock market investing have been apparently displaced by “inflation expectations” or the speculative impulses borne out of the inflationary bias deeply embedded in the present global financial system. As I’ve noted in numerous occasions today’s financial markets are driven by rampant speculation arising from too much money and credit creation and intermediation.

Now as to the argument that lower energy prices help contain inflation is grounded on an equally flawed premise. Dr. Frank Shostak of MAN Financials, in his very insightful contributory article to the Mises Institute, “Will An Oil Price Fall Push Inflation Down?” explains why (emphasis mine)...

``If the stock of money rises while all other things remain intact, this must lead to more money being spent on the unchanged stock of goods — which means an increase in the average price of goods. (The term "average" is used here in conceptual form. We are well aware that such average cannot be computed).

``If the price of oil goes up and if people continue to use the same amount of oil as before, people are now forced to allocate more money for oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down.

``Note that the overall money spent on goods doesn't change; only the composition of spending has altered here, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged. Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

``In other words, it is not possible for rises in the price of oil to set in motion a general increase in the prices of goods and services without the corresponding support from money supply.”

``One could, however, argue that a rise in the price of oil may cause the Fed to increase its monetary inflation and this in turn should provide the support for a general rise in prices — all due to the increase in the price of oil. Even if this were the case, it would have almost no effect on the growth momentum of the CPI. The time lag is simply too long. Present price inflation is driven by past monetary injections.”

In short, it is the amount of money in the financial system that determines inflation and not the price of oil. Talks of lower oil prices as an impetus for lower inflation are merely claptraps employed by analysts in order to justify their opportunistic biases. Put differently, like typical mainstream analysts, they make truth the way the want them to be.

Are the Financial Markets Fighting the FED?

As the US equity markets have been in festivity over the FRESH historical high due to “lower inflation outlook” while simultaneously bidding up equity values in view of more “inflation”, the dichotomy is that Fed officials have been in palpable chorus to admonish about the risks of growing inflation.

Federal Reserve Vice Chairman Donald Kohn recently warned investors of underestimating inflation, ``Don't sell the Fed's concern about inflation short...Further upward movements in inflation would be very adverse to the economy and would, I think, require policy actions.'' Mr. Kohn further notes that his concern is more to the side of inflation than of a sagging economy, ``The risks to my outlook for economic activity may be skewed to the downside, while those to my forecast of gradually declining inflation are tilted to the upside,'' Kohn said. ``In the current circumstances, the upside risks to inflation are of greater concern.''

Charles Plosser, newly installed president of the Federal Reserve Bank of Philadelphia, likewise used his inaugural address to tackle on inflation risks. He commented that ``there is some cause for concern...Despite recent hopeful news on the inflation front, the inflation outlook remains uncertain" and that "there is a significant possibility that inflation rates will remain above those consistent with price stability for some time." Plosser addressed the need to be vigilant and act when necessary, ``So we need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy's long run performance...if unacceptably high rates of inflation persist or public confidence in long-run price stability seems to diminish, additional monetary policy tightening may be necessary."

Fed Chief Ben Bernanke, while acknowledging the substantial weakness in the housing sector was in a quandary on the degree or extent of the probable fallout, ``It is a little difficult how the dynamics are going to play out”, although he waxed optimistic, "At the same time, I think there are some strong fundamental underpinnings that should help the housing market over the medium term, he said. These include: a good job market, strong income growth, demographics and continued low mortgage rates... To this point, other parts of the economy are remaining relatively strong”.

What these Fed officials have been trying to say has been antithetical to the expectations of the market. In other words, the financial markets have been at odds with the Fed!

I’d like to add that the recent speech by Fed Chief Ben Bernanke at the Washington Economic club highlighted the structural imbalances seen with the government’s welfare or entitlement programs, particularly the Medicare and the Social Security System. He notes,

``The fiscal consequences of these trends are large and unavoidable. As the population ages, the nation will have to choose among higher taxes, less non-entitlement spending, a reduction in outlays for entitlement programs, a sharply higher budget deficit, or some combination thereof...

``Assuming it unfolds as expected, the projected aging of the population implies a decline over time in the share of the overall population that is of working age and thus, presumably, in the share of the population that is employed. For any given level of output per worker that might be attained at some future date, this decline in the share of people working implies that the level of output per person must be lower than it otherwise would have been. In a sense, each worker’s output will have to be shared among more people. Thus, all else being the same, the expected decline in labor force participation will reduce per capita real GDP and thus per capita consumption relative to what they would have been without population aging.”

These are hardly bullish factors for US assets going forward as about 78 million baby boomers (birth years: 1946-1964) enter into the retirement age in the coming years.

Remember without adequate savings, you would find retirees selling assets to finance consumption. Further, the imbalances, as a result of present demographic trends, (assuming its continuity) would lead to a smaller ratio of workers subsidizing for each retiree, whose lifespan would have been prolonged by the unfolding technological breakthroughs in healthcare sector, would take its heavy toll relative to the nation’s fiscal position.

While of course, Bernanke and the Fed may use monetary tools to “raise the savings rate” of which he advocates as a principal solution to the present dilemma, perhaps in cognizance of the degree of leverage the country is exposed to, which makes the economy highly interest rate sensitive, he has instead tossed the problem to the legislative branch for resolution via his “recommended” reforms. Bernanke said, ``Reform of our unsustainable entitlement programs should also be a priority. The nature and timing of those reforms will be determined, of course, by our elected representatives.” It becomes a case of a “hot potato” where no one wants to own up to the festering problem.

Election Season: Big Brother’s Hand “The Gorilla in the Room”?

This leads us back to the present fix, “Why are the markets rising amidst a mid-cycle slowdown?”

Taking in another view from a different lens, it is important to consider that with the fast approaching political season in the United States, conspiracy theories have been floated as possible stimulus to the present dynamics in the financial markets. The supposition is that government’s covert hand had been utilized to create conditions that would favor certain candidates or special interests groups whose political interests are at stake.

During the past month, as the seasonal strength favored rising gold prices, an abnormal degree of selling pressure sent gold prices plummeting. I initially suspected of government’s hand in trying to “manage our inflation expectations” by dumping on the gold market, and was proven right, apparently my suspicions have been confirmed by more sales by the European Central Bank according to their recent disclosures. This seems to have been timed as the calendar year for the European Central Gold Sales Agreement closed last September 26^th, where they are allowed to unload 500 tonnes annually.

But it is not only in the gold market where government’s hand was suspected to have intervened; there were signs in the energy markets too.

For one, the widely followed and the largest commodity index, the Goldman Sachs Commodity Index had its weightings reconfigured such that Unleaded gas which was previously allotted 8.72% was adjusted down to 2.3% while the Reformulated Gasoline Blendstock for Oxygen Blending futures contract was adjusted to the upside from 0 to 2.37%. The sharp fall of unleaded gasoline prices which took the broad energy market down with it had been blamed as a political handiwork to the network behind the investment firm once run by Treasury Secretary Henry Paulson. This comes in the light of President Bush’s decision to delay the adding deposits to the US Strategic Petroleum Reserves last April.

Dave Forest of Casey Research identifies another route where perceived manipulation of prices could have been effected. Mr. Forest wrote,

``Another lesser-known influence on oil prices is the “crack spread.” This is the difference between the price that oil refiners pay for crude and the price they receive for the gasoline they produce. Put another way, it’s the profit margin that refiners make on their products.”

``Currently, the crack spread is at - in the words of the U.S. Energy Information Administration - “unusually low levels.” This means that refiners are selling gasoline for little more than the cost of the oil they purchase. This makes no sense from a business perspective… generally in such a situation, refiners would simply up the sales price of their gasoline, improving their margins...

``Why would these companies voluntarily take lower profits? There’s no way to know for sure, but it’s a certainty that the White House and Big Oil are close friends. Witness Dick Cheney’s ties to Halliburton, and George Bush’s background in the Texas oil patch. Might the Republicans be calling in a favor from their refinery manager pals, asking them to keep gas prices down until November 7 has passed?

It is not only in the commodities market, where manipulations have been suspected, the recent rise in the equity markets have likewise been said to have benefited from behind the scenes interventions. Mish Shedlock of WhiskeyandGunpowder quotes John Succo, a professor in Minyanville (emphasis mine),

``In 25 years of trading, I haven't seen stock prices act this way. On any disappointing number (ISM, for example, this morning), stocks react vehemently positively.

``And it's not stock by stock, brick by brick, which is how a stable bull market is built. It is all index led. Tick data today is just another example. They hit +1,000 probably 20 times today and +1,500 twice. Surreal.

``I have my own theories. In a world where geopolitical events are broiling, we have political structures desperate to remain in power. It is possible to believe that in such a world desperate measures like buying stocks by governments (we know Japan did this for quite a while) is certainly plausible. Given the action, I say it is probable.

``The last few years [are] all about liquidity. Who is responsible for that?...And just in time for the elections.”

``I made the big leap yesterday saying governments (no price sensitivity) were buying index futures in the U.S. This is the only answer I see for the odd behavior. Stocks not in an index are severely lagging.

Tick data in our local lingo means either a consummated transaction was a “buy up” (uptick) or a “sell-down” (downtick). What Mr. Succo suggests was that in the face of bad news, there were oddly signs of PANIC BUYING, as measured by an extremely aggressive uptick/buy up counts. Mr. Succo finds no other party except governments being price insensitive as responsible for these recent actions. He says government intrusions are distorting market signals and giving the public the wrong way to price risks and at the same time create a moral hazard problem of “providing easy credit for even worst companies.” Well, that is what I have been talking about, inflationary biases to protect special interest groups.

Of course, except for the gold sales, all of these could be dismissed as outright speculation until some data could be proven to support these allegations.

Bullish Momentum, Flexibility and Trading Advices

According to George Soros, ``One can never be sure whether it is the expectation that corresponds to the subsequent event or the subsequent event that conforms to expectation. The segregation between thoughts and events that prevails in natural science is simply missing.” In this context, I remain uncertain of my convictions over the interim simply because events have turned against them.

Yet as prudent investors we do not fight the tape. In the invaluable words of legendary trader Jesse Livermore ``There is only one side of the market, and it is not the Bull side or the Bear side, but the right side.” We have to remain flexible, in view of these circumstances.

Figure 3: Contraryinvestors.com: Second Year Presidential Cycle Pattern

The tape tells us that momentum favors the bulls at present for reasons aside from the fallacious “lower inflation expectations" most possibly based on several factors such as seasonality; a switch from the weakest to the strongest period of the year, the underlying year end strength of the second year of the Presidential cycle (see Figure 3), ``the end of the fiscal year for mutual funds and other institutional investors on Oct. 31 ends selling by funds anxious to take a tax loss to offset the year's profits and sends institutional money flowing back into the market and measures of short-selling on the New York Stock Exchange and the Nasdaq have reached multiyear highs (a seven-year high in the case of the New York Stock Exchange), so there are still lots of skeptics out there to be convinced.” according to analyst Jim Jubak.

Of course, the supposed government interventions to prop up the markets for political goals could be another short-term booster, which could translate to a run until at least November.

Lastly, I think the most important factor which underpins the entire bullish psyche today is premised on inflationary biases whether through manipulation (alleged government intervention in several fronts of the market) or through Soro’s “expectation that corresponds to the subsequent event” (financial markets ties the hand of a reluctant Fed and succeed to force them to further loosen up the speculative landscape) or through remediation of one bubble to another (shift from equities to housing back to equities?).

As I wrote to a special client, “the inflation genie is what inspires the market to resume its climb upwards regardless of the risks of greater-than-expected slowdown. It's simply called addiction, from which the Fed and the incumbent politicians would be all too willing to accommodate for the primordial purpose of power retention.”

As a last piece of advice; trade only amounts you are willing to risk and importantly MIND YOUR STOPS!

TailPieces

One of my favorite analyst at Morgan Stanley covering the Asian markets, Mr. Andy Xie was reported to have recently resigned due to a controversial email he sent internally but have leaked outside and allegedly caused embarrassment to the firm which led to his rush departure.

FinanceAsia quotes the alleged intriguing derogatory comment on Singapore from Mr. Xie, ``Actually, Singapore’s success came mainly from being the money laundering centre for corrupt Indonesian businessmen and government officials. Indonesia has no money. So Singapore isn’t doing well. To sustain its economy, Singapore is building casinos to attract corrupt money from China.”

Two important quotes come into my mind, one, never to judge a book by its cover and second, from novelist Honore de Balzac, Behind every great fortune there is a crime. Just a food for thought though.

The growing sophistication of Asian M&A

As an Asian bull, I noted that the ongoing financial integration will boost valuations aside from the activities in the regional corporate arena.

FinanceAsia in their latest article "The growing sophistication of Asian M&A" interviewed, Gordon Paterson, Citigroup's head of regional M&A. Here are some important developments from the standpoint of Mr. Paterson...

> “Transactions have been mostly intra-Asia, partly because the competitive landscape has changed. In the past strong domestic companies competing for assets were the exception, now this is the norm.

> “I'd say that today the cost of capital for emerging market companies is very competitive compared to developed market counterparts and this is fuelling transactions. This is across the board and not just related to the fact that the cost of debt has gone down. In many cases, especially across emerging markets, Asian companies view risk profiles of the countries more favourably than their European and North American counterparts

> “Over the years the very limited avenues of financing have given way to local markets with depth and experience to finance deals. The high yield market may not yet be developed to the stage of the US market but it is certainly developing quickly and in the right direction. Liquidity in the market is high hence alternatives and sophistication are increasing. Convertibles, for example, even in sponsor-led deals are playing a bigger role.”

Overabundance of Liquidity, more access to financing, improving corporate profiles and developing capital markets are indeed helping underpin the expansionary M&A activities in Asia.

Go no further, the boom is yet unraveling.

Wisdom of Money:The Way You Think Dictates Your Spending Habits

Wisdom of Money imparts a very important message not just on spending but on investing habits, quoting them verbatim...

Wisdom of Money: The Way You Think Dictates Your Spending Habits

Prosperity thinking can be defined as a trusting attitude that things will work out. It is an optimistic state of mind, and an empowered orientation toward money. Prosperity thinking means aligning our beliefs, attitudes, expectations, goals and behaviors toward realistic levels of abundance, confidence and gain. It increases financial and personal self-esteem and assists in using our feelings and intuition to deal with money more successfully.

Poverty thinking, on the other hand, is a mistrustful state of mind that says things will not work out. It embodies pessimism, fear, and a passive relationship with money. A poverty thinker aligns beliefs, attitudes, expectations, goals and behaviors toward unrealistic levels of scarcity, fear, and loss. It diminishes our financial and personal self-esteem and decreases confidence in handling money. Such messages can cause us to distort how we perceive an event and explain why we react irrationally. Almost everyone, including highly wealthy people, is a victim of poverty thinking to a certain degree.

Prosperity and poverty thinking are two important concepts for understanding the psychology of money. Studying various spending personalities and behavioral patterns provide us with an awareness for making smarter financial decisions of our own. Because the mind takes precedence over our actions, to think and feel more prosperous creates new opportunities for experiencing financial freedom.

World Equities: Knockin’ on Heavens Door or Facing Hell?

``The game is always changing and evolving, and it pays to pay attention to new theories. The bottom line is to always be open-minded, to try and improve the way you do things." -Brian Cashman (GM, NY Yankees)

I have spoken to around three brokers over the week and found all of them overly bullish. I guess that is the nature of brokers, to be bullish because selling stocks or inducing clients to trade would have to come from optimistic expectations.

What drives their bullishness today is no less than the behavior of the Phisix, which has, as pointed out previously, tracked closely the movements of the US benchmarks as with most of global equity benchmarks. The Phisix like their US counterparts seems to be like Bob Dylan’s “knocking on heaven’s door”.

Figure 3: Phisix: Knockin’ on Heaven’s Door?

In theory, excessive bullishness shown by brokers possibly means that most clients who have been egged to buy or enter the market have already done so, leaving little room for more buying activities that could lift the market to higher levels. In short, it is a crowded traded. This, in essence, suggests that inordinate bullishness translates to eventual market tops.

But who has lifted up the Phisix lately? Obviously based on last week’s data foreign money had been a critical factor with locals apparently having reduced their interest over speculative activities over the broad market. Could it be that the local investors have abided by PSE’s admonitions and instead joined their foreign counterparts in accumulating blue chip issues too? Hmmm... Or is there a possible something else brewing at hand?

Of course with the momentum going in one’s favor, would one even care to listen to what may derail it? As we have previously noted, the average investors normally extrapolate the immediate past as the likely path of the future.

I’d like to point out to you that the ongoing activities in the US Treasuries market have not been singing hallelujahs as the consensus have it. In fact, if one looks at the present activities, the rapid decline of the 10 year bond yields point towards, expectations by bond investors of an ‘accelerated’ mark down in the US economic growth cycle and inflation expectations as shown in figure 4.

Figure 4: Stockcharts.com: Bond Yields Suggests Big Slowdown Ahead

While our local brokers have been outright perky, believing that the Philippine markets could perhaps be insulated from external events, we gladly point out that key US equity benchmarks have their own version of “Knockin’ on Heaven’s Door” probably by Avril Lavigne...

Figure 5: Stockcharts.com: Knockin’ on Heavens Door or Facing Hell?

...or if not Ozzy Ozborn’s Facing Hell? As you can see in Figure 5, both key US equity benchmarks have reached critical resistance levels following the recent run-up. Yet, following a touch of these critical highs we have seen them fall back to support levels.

On the technical picture, we find mixed signals with a bias (ok, my bias) towards the downside. Retracing from last week’s record highs draws a bearish “double top” formation, accompanied by the still intact bearish “rising wedge” formation. We also have the Moving Averages Convergence Divergence (MACD) indicators, shown in the lower window, as indicating an overbought position too.

If these US equity benchmarks successfully breaks above the defined resistance levels then I expect the Phisix to likewise sustain its rise and equally break May’s high. Then one should reposition into the market, as global markets are likely to position for a Christmas rally in spite of an economic global downturn. Anyway, world’s endless stream of money has to go somewhere, right?

On the other hand, if the prospective slowdown in the US finally comes home to roost for US equity investors, then expect some pretty big correction, from whence we stand. And so forth with global indices and the Phisix.

So it’s your choice, Bob Dylan or Ozzy Ozborn?

Thai Coup: Hardly A Ripple

``The coup has also highlighted some of the fragility inherent in Thailand's social fabric: so very much of the nation's unity and order rests on the shoulders of one remarkable man, His Majesty, the King.”-Andrew T. Foster, Director of Research, Portfolio Manager, Matthews International Capital Management, LLC

As the military led by a group known as “Administrative Reform Council” surrounded the national seat of the Thai Government to successfully topple Prime Minisiter’s Thaksin Shinawatra’s government, there had been widespread speculations as to extent of the impact of such political development to the regional financial and economic sphere.

One major distinguishing factor that has so far contributed to the triumph of the changeover has been that the military group, who were seen adorned with yellow ribbons meant to demonstrate their loyalty to Thailand’s monarch, His Majesty King Bhumibol Adulyadej, had apparently the blessings of Thai King itself. In short, two possible scenarios emerge: it could be possible that perhaps the King himself impelled for PM Thaksin’s overthrow, or King Bhumibol Adulyadej could have simply endorsed the coup d'état to give legitimacy and avoid further deterioration of events.

Many pundits have thrown their opinions as to the possible repercussions. A surprisingly big number of analysts, mostly from foreign institutions-gleaned through Bloomberg’s interviews, have said that this opportunity could signify a “screaming buy” given that the present political impasse would be disentangled given the makeover. Some like those from Morgan Stanley downgraded their Thai outlook.

In the past I have noted that domestic volatility have markedly ebbed as global markets have slowly integrated...

Figure 1. Yahoo: US/THB; stockcharts.com Thailand’s SETI

As figure 1 shows so far the impact has rather been muted. The Thai baht lost a measly .4% while most of damage was seen via the SET or Thai’s main equity benchmark down 2.7% over the week. Thai bonds even rallied over the week.

To give it a more balanced perspective, Asian currencies have been largely down led by Indonesia’s rupiah down .7% according to Bloomberg, while the Philippine Peso closed .18% to Php 50.35, Malaysia’s ringgit fell .1% to 3.675 and Singapore Dollar S$1.5853. In short, there had been other factors driving the region wide currency declines more than simply the Thai upheaval. This in contrast to the equity benchmarks which were mostly up except for the biggest loser in the Thai’s SET.

For as long as the Thai incident would remain contained, orderly and peaceful, we are unlikely to see a contagion effect towards other the ASEAN nations which I view as rather low impact low probability event. In contrast to the Asian Financial Crisis in 1997, where structural infirmities such as pegged currencies, massive deficits and mountain loads of external or dollar denominated debts gave way to simultaneous capital flight, today’s ASEAN economies appeared to have learned from the past and have adopted a more flexible stance.

As for General Sonthi Boonyaratkalin leader of the coup, like the JRR Tolkien masterpiece the Lord of the Rings, we will see if he will be consumed by the power he arrogated upon himself (what I call “personality based politics”) or indeed stay loyal to the cause of the King and permit for a transition government. By the way, coup has been a way of life for the Thais; this has been the 18^th during the past 60 years for the Land of the Smiles!

Finally, I’d like to make a short comment on the observations of a very high profile contemporary, who made a ‘rationalization’ that Thursday’s decline at the Phisix had been due to the Thai coup. Our expert analyst simply parroted what the average investor would have thought. However, being an analyst, I guess I’d be responsible enough to point out that in spite of the impression of so-called “foreign-investors-pulling-out-of-ASEAN” due to the Thai development, internal market data showed that foreign buying heavily supported the Phisix in nominal and in broad market terms, which simply belies this claim. Further, Ayala insiders or the Zobel group represented by MERMAC sold 6.9% or Php 10.56 billion worth of AC shares to a foreign group on a special block sale also during that fateful day. So listen to your high profile analyst, who is after all, not after the truth, but for publicity (smiles!).

A Brewing Financial Storm or A Wall of Worry to Climb?

``With so much complacency around and with such a high propensity to speculate in just about everything among all classes of investors, a nice crash should not entirely be ruled out.”- Dr. Marc Faber

I know, to some I may have sounded like an alarmist predicting a financial storm ahead. Yet despite my interim morose outlook, the financial markets in particular, the global equity markets continue to react antithetically against these premises.

Yet evidences continue to mount in support of my concerns. Recently, I have assigned the weaknesses seen in the broad spectrum of energy prices to dampening demand in the US. Paul Kasriel, Chief economist of Northern Trust, points to the declining trend of US Petroleum imports in quantity as shown in Figure 1, as probable signs of demand contraction.

Figure 1: Northern Trust: Declining Energy Related Imports

Writes Mr. Kasriel, ``So, there would appear to be more evidence supporting the demand-side explanation for the recent decline in oil prices than the supply-side explanation. If it is weaker demand that is explaining lower oil prices, then do not look for a rapid re-acceleration in consumer spending or domestic spending of any sort. To be sure, a decline in energy prices will lead to stronger consumer spending than otherwise would be the case. But this would be a second-order effect if the decline in oil prices is the result of a restrictive monetary policy.”

The same cannot be said of China whose crude oil imports jumped 35% in August according to Xiao Yu of Bloomberg. I’d like to remind you that during the horrific “risk aversion” selling last May, Crude Oil despite the much touted speculative funds or “terror premium” factor largely attributed to its runup, was largely unaffected by the cross asset class selloff. In short, it is unlikely that today’s actions in the energy sector have been due to merely reallocation by the speculation money.

Figure 2: Fullermoney.com Oil’s Countertrend risk since 2001

Or could it be that the present softening of oil’s prices as merely a technical hiccup over its long term trend as had been the case since 2001, (see Figure 2)?

Analyst Barry Ritholtz echoes a similar view on the apparent corrosion of consumer demand (emphasis mine), ``In the past 16 Federal Reserve tightening cycles, there has been one true soft landing in 1994. I continue to look at that not as impossible, but as a low probability event.... My largest present concern is oil and other commodity prices. It's no coincidence that gas, oil, gold, aluminum and copper all have dropped at the same time. I read that as signs of a global slowing in demand.”

At the same time, we likewise hear parallel sentiments and warnings from the head honchos of the multilateral agency the IMF as Mr. Rodrigo Rato (Managing Director) and Mr. Raghuram Rajan (chief economist).

I watched Mr. Rajan’s interview at Bloomberg where he commented that the world economies have been growing strongly supported by emerging domestic demand. As an example, private demand has made up the bulk of Japan’s economic turnaround as shown in Figure 3 following a decade long slump.

Figure 3: JETRO: Domestic Demand leads Japan’s Recovery

However, Mr. Rajan thinks that while there could be some impact on the world economy by an economic downturn in the US, he is uncertain as to the degree or the magnitude of such impact.

Where the marked deceleration in the US real estate industry had been carried over by mainstream media accompanied by much heralded warnings, such swing in sentiment could have probably prompted markets to react in a diametric fashion, hence, the continued buoyancy (climbing a wall of worry?).

Yet when we talk about sentiments, it is noteworthy to point out that the global equity markets have shown extreme complacency as measured by the VIX chart (see my August 28 to September 1, edition, Market Dissonance: Bull or Bear Amidst A Slowdown?).

Moreover, if one takes a look at how credit spreads are presently behaving in the bond markets, as another measure of sentiment; we see similarly the same pattern.

Figure 4 Yardeni.com: Moody’s Corporate spreads

The spread between the yields of corporate bonds and sovereign debt instruments reflects investor sentiment. When investors are wary over the prospects of the economy, lenders naturally become hesitant to tidy over money to corporations resulting to higher yield differentials. Today, despite the pronounced “moderation”, US corporate bond spreads remain at very low levels signifying a high degree of complacency see Figure 4 courtesy of yardeni.com (Thank you James!).

Figure 5: Bank of International Settlements: Default rates and CDS markets

In addition, the lax environment can be seen in default rates and forecasts as shown in Figure 5, seen through the eyes of the Credit Default Swap markets.

Credit Default Swaps (CDS) are derivative instruments that swap or transfer the risks of credit exposure of fixed income products between parties.

Let’s hear it from the central bank of the world’s combined central banks, the Bank of International Settlement (emphasis mine), ``Major corporate spread indices stayed well above previous lows in the United States despite indicators of credit quality that showed few signs of deteriorating. Moody’s forecast for the 12-month trailing speculative grade default rate for January 2007 was revised down by August 2006 to 2% from over 3% six months earlier, continuing a pattern of downward-revised forecasts over the past few years (left-hand panel). Expected default frequencies, as calculated by Moody’s KMV based on balance sheet information and asset price volatility, were also stable at low levels for firms within rating categories (centre panel). The persistence of higher spreads in the face of a broadly unchanged outlook for credit quality is consistent with indicators showing that the appetite for credit risk never fully rebounded from the turmoil in corporate bond and CDS markets in the second quarter of 2005 (right-hand panel).”

While there have been some signs of turbulence as a result of the global shakeout in May, investors have basically assumed the present placid trends as the future’s trajectory, note the phrase “broadly unchanged outlook for credit quality”. That’s how smug the financial markets are relative to risks. Evidently, that’s also a product of an ocean of liquidity. Now again, we question this tranquil outlook in the face of economic growth “moderation” whose repercussions remain undetermined but whose markets has been obviously priced for “perfection”.

Figure 6: PSE and Dow Jones World Index

Figure 6 shows that the world markets have been, as I have pointing out ad nauseam, largely behaving in synchronicity. The sheer gargantuan size of the liquidity pool and its continued growth, in the global financial system has led investors to stretch for returns. Further, the digitization of money and credit plus the technology enabled integration of the financial markets has allowed capital markets to deepen, reduce barriers and domestic volatility, facilitate for a seamless flux of capital that has prompted for resonating movements of these benchmarks. For instance, the Phisix and the Dow Jones World Index has moved as one or has seen a stronger correlation over the past quarter relative to the previous period.

I have to admit though that the recent behavior of the Phisix had been that of an upside momentum following last Friday’s breakout. Volatility as measured by the Bollinger band seen in the upper window appears to signify continuity of such upside momentum, again in consonance with the activities of world markets, with particular emphasis to the US markets.

Of course for the time being, my fears could be misplaced considering that one, the financial environment remains unrestrictive which means contemporary avenues or channels of liquidity remains as potential fuel for any added upside moves. Besides, the loose lending standards may cushion whatever shortfall US consumers may yet face over the interim and may extend its heavily levered spending binges.

Eric Roseman, Investment Director of the Sovereign Society wrote (emphasis mine), ``When long-term U.S. interest rates are below 5%, it's probably not the time to get bearish on global economic growth and commodities. Keep in mind that previous economic recessions began with the Federal Funds rate closer to 7% and long-term rates at 6.5%, or higher. Global liquidity has eased somewhat since mid-May. But overall, bank lending is still very robust around the world and companies are still logging respectable earnings growth, though likely to be moderated over the next several months. Unless a geopolitical event happens that tips the global economy into recession, this bull market will still be alive and kicking.”

Second, lower energy prices and lower yields are both stimulative. Lastly there are signs of incremental increases in wages and accelerated capital spending that may yet cushion the decline in the US real estate industry and extend the spending binges of the overstretched consumers.

Yes, my fears may have yet to turn into reality but I am not throwing caution into the wind and withdrawing my cynicism towards the present market climate until we see more vivid signals from the financial markets that would merit increased exposure. Instead, I would rather take this opportunity to trade the market.

Finally, my suspicions on gold’s recent downdraft have been confirmed. According to this Reuter’s report, ``According to the weekly balance sheet issued by the European Central Bank, gold holdings fell 114 million euros in the week to September 8, the biggest drop in two months. The ECB said this was due to sales by two central banks, but did not name them. Separately, the Bank of Portugal announced that it had sold 20 tonnes of gold "in recent months", taking its total for the current year of the agreement to 45 tonnes.”

Governments will do anything as to achieve its short term goals usually with long term unintended consequences. When governments distort markets we know that the effect is likely to be short-term. Moreover, governments have had ignoble track records in the markets. One can just be reminded of Britain’s Exchequer Gordon Brown controversial gold sales in 1999 which incidentally was at the record low of around $250 per ounce. And to consider governments are suppose to know what’s best for you and me. Just imagine the losses to the British taxpayers borne out of this miscalculation. On this premise alone, I see a continuing bullish trend on the monetary metal even as it may be weighed down by short term volatility emanating from government interventions.

Foreign Funds: Rotation to the Telecoms?

In the local market, recently one sector had been a steady beneficiary of foreign portfolio inflows over the past few weeks. It appears that an ongoing rotation abroad has also found a similar trend here.

Figure 7: Stockcharts.com: Rotation towards the Telecoms?

The chart in Figure 7 shows that in the US, the S&P 500 Telecommunication Services Index (black line), which I recall in 2002 had been strongly correlated with the movements of PLDT, has corralled the bulls for an accelerated upside momentum.

We see similar upside momentum over at the Dow Jones Emerging Market Telecoms benchmark as well as a spike in PLDT shares (lower window) traded in New York. From the looks of it, these fund rotation may continue given its current motion.

Fundamentally, if one considers subscriber growth as basis for projecting revenue growth, I find that the fantastic growth clip for telecom stocks as having peaked out. However, as I have noted the hunt for yields may continue and the formerly out-of-flavor telecom issues abroad may equally find a spillover at local issues.

If the bullish momentum towards these issues continues to lead the market over the interim, one may consider surfing them.