Exogenous Risks Amidst A Milestone Phisix High

``It is a mistake to try to look too far ahead. The chain of destiny can only be grasped one link at a time.”-Winston Churchill

As expected, the porous events unfolding abroad finally permeated to our own market as the Phisix blasted away from its May high hurdle to establish a 7-year landmark! Exciting right? This means that the July 5, 1999 high of 2,632 and its respective close of 2,621 is merely a breath away from last Friday’s close! A breach of this threshold level suggests that the Phisix would take at aim at its next goal of 3,447.6 (reached last February 3^rd 1997), its ALL-TIME high!

Figure 1: Stockcharts.com: Phisix Charges to a 7 year high!

As Figure 1 courtesy of stockcharts.com shows, the Phisix now appears to be headed for the resistance level of its current channel (two blue lines) estimated at 2,670-75. Present momentum could push it towards these levels before a retreat ensues. But remember, I wouldn’t put so much emphasis on the Phisix alone, as I have previously noted, activities in Wall Street appears to be directing the flow dynamics of the world financial markets, inclusive of world equities or the Phisix. In a financial world with increasingly seamless borders, a singular focus on domestic analysis as drivers for the local market is a grave mis-analysis.

This outperformance of the Phisix, up an astounding 2.35% for the week, was surprisingly second only to Pakistan’s Karachi 100, which had a scorching 5.87% advance. Of course, this has been a worldwide phenomenon. World equity markets or even emerging market bonds have been on fire lately.

If you ask me anew, what all these “optimism” is all about? My repeated succinct reply as enunciated in my previous outlook is that all these have been mainly liquidity driven (expectations for loose money environment or room for further leveraging or veiled inflation channeled via asset prices).

Today’s financial world has been at the core of world economies, especially that of OECD economies or of the industrialized world. The financial markets have greatly outdistanced in magnitude the real value of the exchange of goods and services. Credit markets have grown itself a size with the help of technology, to engender innovative “financial intermediation” products enabling investors to shore up speculative positions compared to real investments. Again, the praxeological (``individuals engage in conscious action towards chosen goals”-Murray Rothbard) impulse...the stretch for yields!

Massive productivity growth coupled with weak real investments has led to outsized global current account imbalances which at the same time fueled worldwide asset speculations. In fact, one of the peculiar outgrowth of today’s financial structure has been that of “savings” or “surpluses” (Bernanke) from Emerging market economies “financing” the industrialized world. To say differently, believe the unbelievable...the Poor have been funding the Rich! Talk about inequalities or absurdities!

Now since the world is highly dependent on “wealth effects” from the world’s major consuming nations, it is but natural to revolve around on loose money/financial conditions to buttress further leveraging in an ever growing reliance for asset-based economies in the industrialized world. Hence the so-called spin on “low inflation expectations” which are nothing more than camouflaged excuses or alibis for maintaining the status quo or pining for the perpetuation of conditions conducive for more leverage. Give an inebriate more alcohol or an addict more of the substance!

Moreover, in a world of diminishing returns and intense competition, greater leverage is necessitated to accentuate yields. Last week, I quoted IMF’s Rajan who simply validated our standpoint that liquidity drivers have not been dependent on the traditional banking sector. He notes that “80% of value added is found outside the banking sector”, where non-bank activities has been “increasingly central” to economic activities and not to its traditional role of “passive holder of assets”. Thereby, several analysts focusing on bank aggregates as measure of world liquidity have been bewildered if not stupefied by the baton turnover from stocks to real estate and now back to equities. Yet, this is what has been occurring, in the US, to quote favorite analyst Doug Noland, ``The sharp slowdown in home sales activity is offset by more aggressive home equity, credit card, and small business lending. Almost across the board, commercial lending volumes are strong.” Inflation manifestations have been rotating.

Nonetheless, the greater the leverage, the higher the risks! But who is to say the music should stop (not me!), when the going even gets better! More dosage please?

Let me cite you an example of what non-traditional non-bank liquidity to the ever-increasing levered world means, from Randall Forsyth of Barron’s, ``Credit default swaps allow investors in risky assets to, in effect, buy insurance against something bad happening, just as a homeowner transfers the risk to an insurance company writing the homeowner's policy. But flood insurance has not reduced the chance of a hurricane. Indeed, flood insurance has increased the chance of a hurricane hitting a populated area by letting people build houses at the shore, seemingly without risk. In the same way, credit derivatives don't eliminate credit risk but arguably facilitate it. In so doing, the risk to the entire system has increased.” As somebody else or some other party takes on these transferred risks, risk taking appetite becomes even more proliferate or expansive. People or the investing public become less risk averse and gravitate to even illiquid stakes, which becomes a question of growing “Moral Hazard”?

Allow me another pertinent quote from IMF’s Raghuram G. Rajan (emphasis mine), ``The problem when the world has excess desired savings relative to investment, and when central banks are accommodative, is that it is awash in liquidity. Many investment managers can enter the business of liquidity provision, and even as they take ever more illiquid positions, they compete away the returns from doing so. The point is that current benign conditions engender "illiquidity seeking" behavior. But they could have worse effects.”

Figure 2: Daily Wealth/Stockcharts.com: Where is the Fear?

And in the circumstances of a highly levered world, risk taking via more margin or borrowed bets becomes increasingly systemic!

Borrowing the memorable words of Nixon’s economic adviser Herb Stein, ``if something's unsustainable, it tends to stop”. Oh yes, it will one day. As to the timing, this is greatly beyond my ken or anyone else.

Now to balance your ecstatic outlook, figure 2 shows that US equity markets showing signs of pervasive confidence...the public getting lax and showing signs of more complacency!

Back to the Phisix, this next chart has been a favorite of mine (see Figure 3), I’ve been showing this since 2002 (Recall, Index Trading Edition?) and more importantly this cyclical chart has performed “Luckily” in my favor, thus far, even as the consensus had been stridently cynical then.

Figure 3: Phisix 20-year chart: Working towards a full-cycle?

In conversation with some market participants, to my surprise I figured that only a few have been seemingly aware that the Phisix is only about 25% shy of its record HISTORICAL high of 3,447 in 1997.

Let me reiterate, if I am right about the secular phase for our domestic market, which is supposedly operating in an environment under an advancing or (drum roll please) bullmarket phase, then the 1997 high would eventually be taken out in a cinch.

I may not be sure of the timeframe simply because I am not your Madame Auring (a famed local seer). I can’t read the minds of the investing public overnight, but certainly can use tools or indicators to measure it....(read my lips!) O.V.E.R.T.I.M.E. Time distinctions vary a great deal relative to risks-return analysis, example the shorter the time frame the greater the risks.

However, it is important to note that it is the characteristic of bullmarkets to replace previously established highs with FRESH record highs. That is why I’ve repeatedly said to you that at least 10,000 Phisix is a possibility in the future. No, I didn’t pick the figure from the sky...the rising Peso, restructuring of regional investment, trade and financial flows, growing evidence of increasing financial integration with our neighbors, demographic trends, et.al...as LONG-TERM fundamental drivers behind such target.

But enough of cheerleading, there is no shortage of immodest Panglossians in today’s perky atmosphere. We must continue to guard against complacency. Nonetheless, in my view, the epigram of William James (1842-1910), US pragmatist philosopher captures overconfidence at work, ``A great many people think they are thinking when they are merely rearranging their prejudices.”

Lagging Mines: Not For Long I Suppose

``Value is not embedded in the material properties of any good or service. Neither does a thing acquire value merely because labor was employed to create it. Value is not dictated by the production process or social conditioning. An economic good is valued because an individual mind values it. It is a product of the human mind.”-Jeffrey Tucker, Fortune Cookie Economics, Editor Mises.org

Figure 4: Rising Tide Lifts All Sectors?

Figure 4 shows, that aside from the rising general breadth of the market as the Phisix advances, sectoral indices (Property-candle; Banking- Red, Holdings-Violet, Services-Green, Commercials-Blue and the Mines and oils- Orange) have likewise been in close chime to the upside....except for the mines and oils (which outperformed earlier on the year).

The global selldown in the metals and energy prices have been used as a yardstick for “lower inflation” and has been a significant contributing factor to the weakness in the mines and oil sector of late. Aside, the outstanding gains, during the 1^st semester by today’s lagging sector, have emasculated somewhat the overwhelming bullish sentiment built then. This could have possibly influenced its latest underperformance. But signs are such underperformance wouldn’t last...

Figure 5: Growth Stock Wire/Stockcharts.com: Unblemished seasonal Record for Oil stocks since 2002

Jeff Clark of Growth Stock Wire pinpoints consistent October bottoms since 2002 for the Oil stocks sector abroad as shown in Figure 5. With today’s rampaging equity markets, there is such possibility that global economies could surprise to the upside for the last quarter this year despite the much touted real estate slowdown.

It is important to note that the rotational activities in the asset sector indicate a shift in the inflationary manifestations which remains copious in the system despite the actions of the US Federal Reserve and the world central banks (remember, Rajan’s 80% non bank value added in the financial system). This could suggest for a subsequent rise in energy prices too and a corresponding rebound in metal prices, led by gold (looks consolidating as with global mines and poised for a second wind). As an aside, the pronounced cut in productions by OPEC could be a factor too (but I doubt so, considering their previous tendencies to cheat on quotas).

I also think that the eve of US elections could presage for a rebound in benchmark commodities, thereby, percolating into the domestic arena too.

Figure 5: Kitco: GFMS Base Metal Index: What Weakness?

It’s difficult to suggest for a demand induced weakness, as I had been earlier expecting or suspecting, if as measured by commodities, we see base metals on a blistering streak, Figure 5. As you can see, inflation manifestations reveal itself in different avenues unequally.

Consequently, improving OVERALL sentiment in the local market plus a turnaround in the prices of oil/energy (hopefully) should boost prices of local mines/oil to run at par with the rest of the market possibly until the yearend, in condition that external markets remain favorable.

However, we must be reminded that there are risks out there as described earlier, mostly exogenous in nature that are real enough to heighten volatility and destabilize world markets including ours and could risk expunging present gains. We are living in very interesting times.

Genius is A Rising Market! Prudent Investors as Contrarians (UPDATED)

``Believing that the market is “wrong” is one of the worst mistakes a trader can make. When an investment goes against an ego driven trader, they tend to play the blame game. It must be the economy... the Fed... the price of oil... bad earnings from another company in the sector. In other words, the blame is placed on everything, except for their own infallible analysis.”-Charles Delvalle, Investor’s Daily

FOUR years ago, when I began this crusade, the stock market was anything else but attractive. Following the meltdown sparked by the Asian Crisis, the Phisix was practically a bête noire. No one wanted to touch or even discuss about it, everyone was “risk averse”, and news about stocks were relegated to the inside pages of business dailies. I even recall my principals photographed in prayer alongside all other brokers at the trading floor, signifying desperation for a turnaround then.

As the Phisix entered to its nadir following several years of gut-wrenching downturn accompanied by intermittent rallies, hardly anyone had the gumption to talk about market fundamentals such as earnings, revenues or economic turnaround simply because sentiment or market psychology was dour.

In several occasions, peso volume turnover even hit less than 100 million pesos. More remarkably, despite the record revenue and earnings, PLDT was sold down to a low of Php 209 pesos per share during the last quarter as foreign money sold on the issue in line with the furious selling in the telecoms issue worldwide. The following year a foreign broker even declared our market going nowhere.

Except for two brave souls who dared enter the market then, basically everyone I knew of shunned the prospects of recovery and had written off stocks entirely. There are those whom I recommended to rejigger their portfolios and they reacted by selling out and have not seen them return since.

TODAY, with the Phisix registering over 150% of gain since then, almost every active participants have come up with diverse rationalities to justify their positions, to name a few, growing earnings, rising sales, expanding production, low price-earning ratio, stock buybacks, a cash hoard, a jump in dividends, mergers and acquisitions, backdoor plays or even an economic turnaround.

To assert that the market had been driven by foreign fund flows underpinned by the globalization of the financial markets, which has likewise steered on the advancing phase of our stockmarket cycle is simply unacceptable to many simply because such is partially premised upon luck. Foreign money represents externalities. Except for me, no one wants to be called “providential”, as present successes have to be attributed to skills in stock picking. In short, in general no one wants to be deemed as having been “Fooled by Randomness” to quote mathematician trader Nicolas Taleb.

Based on Pinoyfinance.com data, as the Phisix is up by over 20% year-to-date, of 264 issues listed (265 ex-Tuna Alliance) 176 issues have advanced (as of October 16) or 66.67% compared to 15.5% decliners while the rest are unchanged. This translates to about 7 advancing issues for every 10 issues. Put differently, as the market advances, the gains have been broadening as the public becomes more convinced of the persistence of such progress.

As I have previously argued, the markets are essentially an expectations game and expectations then and today have radically evolved. This is also evidence of how the axiom “Rising Tide lifts all boats” has been unfolding. You don’t need a guru or a star analyst to tell you that; expect everyone in the know to highlight or bruit about their share of “ability-based” glory. Yet, truthfully as the gains accrue, publicity aside, to quote a Wall Street maxim, ``Even Turkeys fly in Strong Winds”.

Essentially it is not much about picking a winning stock, but rather how one manages such gains or one’s portfolio under such environment. As they old proverb says, ``the proof of the pudding is in the eating.” It is widely known abroad, that active fund management or fund managers (no matter the sophistication of their methodologies), in general, has failed to beat the benchmark indices. According to a study by Investment Managers, Tweedy, Browne Company LLC (emphasis mine), ``Empirical research concerning successful long term investment results indicates that under-performing the S&P 500 25%–40% of the time is not uncommon for successful investment managers. In fact, it appears to be normal. Investors who understand this are more likely to stick with a perfectly valid long-term investment strategy in the inevitable and, we believe, normal, under performing periods. It is all too human, in the field of investing, to extrapolate recent results, which have no statistical significance, rather than emphasizing long-run odds and empirical data. Your own psychology and ability to handle the emotional ups and downs of investing are likely to be important determinants of your long-run investment success.”

All these could be summed up in 5 simple words: Genius is a Rising market!

Of course, as conveyed above, one may argue that some issues may outperform. That is true. But altogether, as the market advances the gains will percolate over the broader market. The public will be more confident and complacency will set in. That is the general function of cyclicality. Yet, this is where the prudent investing comes in play, because complacency increases the risks factors.

NO trend goes in a straight line, though. There will be bumps along the way. Although markets will be accommodating as it appears to be in an upside cycle, there are “tail” risks involved. And these risks, once realized could leave investors holding an empty bag or even delay or reverse the present cycle. And this has been the thesis of my discourse since.

AS practicing Prudent Investor, my self-assumed role is to challenge or question the conventional or popular wisdom, even if, at times, I do agree with the prevailing premises. By playing the devil’s advocate, we decrease our tendency to get “married to a position”. It is by nature of prudent investors to be contrarian.

Because my concern is about risks, I try to identify them and the possibilities or probabilities and adjust accordingly on my approach to the market. And this through my letters I share with you.

IT is not my intention to offend anyone and if I do come on strong at times, I seek your understanding. I just feel, that growing complacency arising from consensual wisdom, popularity and/or inordinate cheerleading represents greater risks and therefore, to my limited audience, a word of caution. I do not expect you to agree with me, but to my perspective it is imperative for me to disseminate or impart the message of risk control. It is up to you to exercise caution. Doing your own homework is the best way to reduce risk.

I have also outlined to you the conflicting income goals of a broker and an investor, such that it is the responsibility of investors to be aware of such disparities and act accordingly.

EVEN relative to governance I come to debate on the conventional thoughts. Nurtured to believe that governments are everything in our lives, I only come to realize only in the last two years, influenced mostly by the Austrian School of Economics, or the Ludwig Von Mises Institute, that governments by its intrinsic nature play a big role in inhibiting progress. Look no further than reading your history books or at the unraveling developments around the world today.

I have actively marched the streets in the past revolutions and found to my dismay that the changing of guards for a dream of a better alternative has not led to any manifest progress. I came to realize that the decadence of the state of the country’s economy emanates mainly from an enlarged government bureaucracy, an offshoot to the deeply embedded dependency or welfare culture.

In principle, the larger the government, the risks is of greater inefficiency and more bureaucratic corruption, aside from, of course, competition for resources with the private sector thereby choking market forces, which dampens the entrepreneurial “animal spirits” (Keynes) and impedes economic progress.

Changing of guards or forms of government would most likely be unsuccessful unless it reduces the participation of government in the economy. It is called “economic freedom” to some institution. Yet, mainstream media continues to highlight otherwise. I have thus argued for freer markets and lesser government as a challenge to the conventional wisdom.

As you can see, my contrarian approach requires an open and flexible mind while at the same time continually challenge the premises of our underlying biases.

Global Equities Celebrate; Competitiveness as Drivers to Equality

``Once everything is in a state of flux, everything which happens is an innovation. Even when the old is repeated, it is an innovation because, under new conditions, it will have different effects. It is an innovation in its consequences … In any economic system which is in a process of change all economic activity is based on an uncertain future. It is therefore bound up in risk. It is essentially speculation."-Ludwig Von Mises

What an incredible week for world equity markets, even if our own Phisix simply meandered along! Alongside the remarkable “melt-up” momentum in the US, a significantly large segment of global equities similarly treaded on either milestone highs or within near record thresholds.

Figure1: Bloomberg: Euro Stoxx 600

Except for the Arab region, even several African bourses have been enjoying a wondrous spectacle of late. Figure 1 is a representation of European markets via the Euro Stoxx 600, a broad based capitalization-weighted index of European stocks which duplicates the Dow Jones Global Indexes Europe Index, according to the Bloomberg, is seen in new record territory.

The wonders of real-time “seamless borders” money flux or the “integration” of global financial markets enabled by the internet platform, as shown by our own region...

Figure 2: Bloomberg: Hong Kong’s Hang Seng and China’s Shanghai Index

I recall a speech from a local tycoon, Mr. John Gokongwei Sr. to a graduating batch of an elite school in 2004, where he said, ``War was the great equalizer. In that setting, anyone who was willing to size up the situation, use his wits, and work hard, could make it!”

It may not be war today, but rather technological breakthroughs and accelerating trends in globalization as possible equalizers. These developments have spurred increased competition and innovation through entrepreneurship on a global scale. While others may argue about the entrenched inequality brought about by the advent of the DIGITAL Divide, I think this view is latched upon linear projections using the outmoded past, which essentially dismisses the explosive creativity and innovative growth curve (Moore’s Law) brought about by increased competition through the burgeoning laissez faire system.

As an example, Forbes recent list of world billionaires reveals of a broadening trend of the privileged class, ``In its inaugural ranking of the world’s richest people 20 years ago FORBES uncovered some 140 billionaires. Just three years ago we found 476. This year the list is a record 793, up 102 from last year. They’re worth a combined $2.6 trillion, up 18% since last March. Their average net worth: $3.3 billion.”

Billionaire philanthropist George Soros noted of the importance of the equity markets to wealth creation when he wrote, ``The stocks market is one of the most important repositories of collateral”. And guess what, the same Forbes article of world billionaires appears to validate his perspective, according to Luisa Kroll and Allision Fass, ``Strong stock markets around the world (the U.S. being the notable exception) contributed to this surge in wealth.”

Figure 3: India’s BSE 30 and Singapore’s Strait Times

Now with surging stock markets around the world and its assumed continuity, we could see a growing roster of the elite.

While based on our faith we would love to see an egalitarian society, where everyone is “equal”, the reality yet today is that NO one is equal; not physically, mentally, emotionally, behaviorally or even spiritually. That’s what makes us distinct individuals aside from our DNA genetic codes (after being mapped we could get cloned!). Again quoting George Soros (Alchemy of Finance), ``We live in a real world, but our view of the world does not correspond to the real world.”

History tells us that numerous governments have built political structures out of this “Utopian” ideals, such as communism, socialism, totalitarianism etc.., yet, like most centralized governance system, corruption, destitution and ruination has been the typical end result.

Competition is what, I think, drives equality, because it simply brings out the best in the individual, organization or a society. Aversion or Fear of competition is usually what triggers desires for wealth redistribution via coercive taxation camouflaged by “Utopian” goals, simply because a lot of people essentially want something for nothing.

Nonetheless, this “Money-for-Nothing” attitude can be seen prevalently in the stockmarket, where the average investors recklessly chase on faddish issues and give priority to “tips”, instead of comprehending the structural dynamics of investing and risk management.

Figure 4: Bloomberg: Malaysia’s KLSE and Thailand’s SET

Figures 2, 3 and 4 shows how some key markets in Asia broke to new high grounds last week. Even Thailand’s SET following the successful ouster of its PM via a military coup, has retraced recently lost grounds.

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.