US Markets: Technical Warnings and the Yen Carry

``Probability is omnipotent and omnipresent. It influences every coin at any time in any place, instantly. It cannot be shielded or altered. And probability is not limited to coins and dice and slot machines. Probability is the guiding force of everything in the universe, living or nonliving, near or far, big or small, now or anytime.” Scott Adams-creator of Dilbert, in God’s Debris

I have been saying all along that the recent rally in Wall Street has provided for a bullish backdrop in global equities, premised on a Goldilocks scenario.

Recently, considering the recent turn of events much like in the Philippine setting, the US markets looks technically overextended with an increasing likelihood for a sizeable correction in the near future. A correction in the US markets should extend to its global counterparts given their present high degree of correlation.

Quoting the normally bullish BCA Research on their invaluable insights (emphasis mine)...

Figure 4: BCA Research: Technical Warning for US Equities

``Momentum has started to negatively diverge from U.S. share prices, with the 13-week rate of change grinding lower despite new highs in the market. This diverging pattern was evident prior to the past four market consolidations or modest corrections since 2003. Another warning sign comes from our composite sentiment index, which has crested after reaching an optimistic extreme. A peak in sentiment from an extremely stretched level typically indicates that participants are fully invested and may be starting to retreat. Fundamental support for a setback in share prices includes declining earnings growth and reduced prospects for monetary stimulus. The recent back-up in Treasury yields has been sufficient to create a near-term headwind.’

In other words, BCA thinks that the prospects for a rate cut has been greatly reduced and the risks have now shifted possibly to a prospective tightening in the view of the higher Treasury yields.

In addition, as we mentioned before, in the light of a mid-cycle slowdown, the risks is tilted towards a deceleration of earnings growth rate which could somehow impact price-earnings multiples operating under the conditions of a “Goldilocks” rate-cut scenario. An implied prospective change of expectations from the present conditions could trigger such pullback.

Figure 5: stockcharts.com: Potential Jolt from Carry Trades

There are other possible sources of triggers that may induce a near term retracement, such as the unwinding of “carry trades”, and a possible rise of default incidences that could rattle the untested derivatives market and prompt for a cross asset market downside volatility contagion.

We should not forget that May 2006’s cross asset class sell-off has largely been in response to Japan’s administered increase of its bank reserves requirements which virtually prompted a spike in the Yen, the “funding currency” and consequently a selloff in the global markets, as shown in Figure 5.

The enclosed portion of the chart shows of how the spike in the Japanese Yen (red candlestick) coincided with the sudden selloffs in the US S & P 500 index (black line) as well as in the Phisix (lower panel).

Since a “carry trade” involves borrowing money from a low interest rate country, such as Japan’s Yen and using the proceeds to invest in higher yielding assets, where the profits obtained are derived from the spreads; a sudden tightening of the monetary policy or an abrupt jump in the value of the funding currency, which in this case is the Yen, could trigger a sellout in the invested assets which had been leveraged against the Yen for short covering.

Figure 6: S&P: Compelling Spreads

The compelling low-yield spread by Japan’s currency relative to the others has made the Yen carry a common feature in today’s global financial market’s arbitrage as shown in Figure 6. It is estimated according to some sources that about US$ 1 trillion could be at stake on the Yen carry.

In other words, a great deal of today’s liquidity driven markets could have been generated from the leverage arising from the carry trade arbitrage.

While the Yen today continues to drift along the four year lows against the US dollar, possibly providing fuel for the sustained run-up in global equities (see again figure 5), any precipitate departure from its downtrodden state could send tremors throughout the financial markets similar to that of May of 2006.

While there are those who argue that today’s highly sophisticated markets may have justifiably produced low volatility or reduced risk premiums or diffused risk concentration among the asset markets to allow for increased capacity to absorb greater leverage, it looks to me like risks have been simply remolded into different forms whose full blown impacts have yet to be seen and felt.

Financial Globalization’s Pluses and Minuses

``We can chart our future clearly and wisely only when we know the path which has led to the present." - Adlai E. Stevenson (1835-1914)

When we talk about financial globalization, we talk about greater accessibility to financing, a deepening of capital markets, a broader scope of risk-sharing capabilities, a wider base of asset ownership, more array or selections of financial instruments, and increasing profile of financial markets, participants and institutions. And these have been unfolding right before our very eyes.

Just to give you a short clue, market participants today includes the emergence of the “sovereign funds” class or public institutions assigned by national governments to allocate sections of their excess reserves into the global asset markets. In other words, public funds have now morphed into quasi-hedge funds which now compete with private funds for the same purpose, to generate “ALPHA” returns.

I have shown you how closely correlated the movements of our markets have evolved with that of our neighbors or with global benchmarks. And in such context, as much as the benefits accrue, the risks have been increasingly interrelated or shared.

To quote IMF’s Managing Director, Rodrigo de Rato in his recent speech (emphasis mine), ``In the last decade, the global integration of capital markets has become even deeper. As a result, both the benefits of free trade and free capital flows and the risks associated with volatile capital movements have increased....We have learned that shocks in the financial sector can spread quickly to other sectors, and that the interlinkages between sectors must be taken into account.”

In today’s world where capital markets greatly overwhelm the exchange of goods and services, it is of no doubt the principal role played by the financial sector.

And it is on similar grounds, where as an Asian bull, I believe trends towards the “financial globalization” theme will drive the region’s assets (including the Philippines) over the LONG RUN to unprecedented heights;

>mounting trade surpluses which represent the wealth shift phenomenon,
>outsourcing and offshoring signifies a shift of the manufacturing capacity or increasing trends of industrialization,
>per capita convergence or the rising middle class,
>intensifying regionalization trends or lesser dependence on a single market or source of finance,
>growing consumer class,
>beneficiary of the science and technology revolution,
>favorable demographic trends,
>faster growth rates
>growing supply of skilled labor and
>rising productivity

Yet, in the face of these substantial auspicious circumstances, the Asian economies have not been adequately supported by its financial markets which are largely fragmented, underdeveloped and over reliant on the traditional banking sector as source for financing as shown in Figure 1.

Figure 1: IMF: Asia Underdeveloped Markets

The 2006 outperformance of the Philippine Phisix (+42.29% in local currency) and Indonesia’s JKSE (+55.3% in local currency) could be due to the extremely low levels of Market Capitalization relative to GDP, which in 2004 represented 34 and 30% respectively.

And this is one of the reasons why the present global structural imbalances thrive; Asia’s surpluses continue to be recycled into US assets, which tacitly supports the highly indebted US consumers as manifested by the exploding trade deficits, simply because its capital markets do not have the depth and sophistication to absorb all these excesses surpluses. And this will nonetheless change.

According to IMF’s Agnès Belaisch and Alessandro Zanello (emphasis mine) ``In the future, trends in regional trade and abundant liquidity are likely to serve as catalysts for stronger financial linkages throughout the region... A strengthening of regional demand and trade growth will independently stimulate Asian asset markets and tighten regional interconnections. Better-linked regional financial systems could provide funding and hedging instruments to support the region's trade activities. Overall, Asia's growing intraregional trade will catalyze greater financial integration and, in turn, be stimulated by it.”

In short, the trends towards further capital markets deepening and integration looks like a monumental and possibly “irreversible” force to reckon with. Such is the reason why I am bullish with non-bank finance services which I think should benefit significantly from this seismic transformation, aside from of course, the general asset classes of Asia.

In today’s globalized financial environment where money moves “freely” in search of yields real time, let me show you why foreign money should continue to pour into Asian assets. In the eyes of the widely followed BCA Research, real yields matter (or bond yields deflated by inflation indices)...

Figure 2: BCA Research: Searching for Yields

``The Chart compares real bond yields and the basic balance for key emerging markets. Countries with high real yields and strong external positions (emphasis mine) offer the best risk/reward profile for investors in domestic bonds—that is, those in the upper right area.” wrote BCA Research.

As you can see in Figure 2, the Philippines alongside its ASEAN contemporaries have been labeled as good value in real bonds yields (domestic currency), with mature East Asian bonds in somewhat the lesser attractive class. Meanwhile, US and Australian bonds have been shown as the least attractive.

Now relative to RISKS I believe, the housing recession in the United States has been the biggest mystifying factor whose effects could undo yet all the present gains seen in the liquidity driven global financial markets.

Figure 3: Northern Trust: % changes of New and Existing Homes

Mainstream analysts have recently adduced to several positive data in the housing industry as signs of a bottom. I am highly skeptical of this.

Bottoms or tops, or major cyclical inflection points do not come without capitulation from either bulls or bears. Because markets are psychological in nature, they tend to shoot beyond the norm; that is why you have such phenomenon as Mania, Panics and Crashes. As the Wall Street axiom goes, Markets climb a wall of worry, and decline on a ladder of hope.

What gives the bulls the ammo for their continued exuberance is the absence of credit-related crisis or fallout from risky exotic mortgages or derivatives yet. However, it is too premature to discount such possibilities, as signs of incipient raptures could have emerged, from Bloomberg’s Caroline Baum, ``A few sub-prime lenders have gone belly up. Signs of additional distress are just starting to show up in larger home- loan companies. Last week, IndyMac Bancorp Inc., the second- biggest independent mortgage lender, said its fourth-quarter earnings would miss forecasts because of deteriorating credit quality in the home-loan market.”

This view appears to have been shared by the illustrious Yale Professor Robert Shiller of the Irrational Exuberance fame in his latest interview in Bloomberg (emphasis mine), ``Why hasn’t the weak the housing market affected retail sales? Or why hasn’t consumer confidence fallen’ more? Well the easy answer to that is it hasn’t really started falling yet. It’ s the rate of increase that’s been going down for two years now, and its just starting to fall....I mean cities are down 1-2%, its not happened yet, so I am interested in what’s gonna happen next year.”

This means mainstream analysts have been looking at the rate of change instead nominal figures in determining the scope of the retrenchment of the housing industry.

Despite the declining rate of change, as shown in Figure 3, the nominal price levels suggests that housing levels remains on the high side, ergo, the effects of the fallout has not yet been visible. In other words, market participants have been in a state of denial and have not capitulated, so the likelihood is that while there may be interim recoveries, the bottom in the housing industry in the US has yet to be found.

In addition, Mr. Shiller implies that as nominal price levels decline, things can get rather interesting or possibly, the ramifications would be more evident. And we must not forget that since markets functions as discounting mechanisms, where if such effects would be more apparent by next year, stressed or not, the market’s price signals should soon be reflective of these.

Further, as I have repeatedly mentioned, Derivatives, “Financial Weapons of Mass Destruction” to Warren Buffett, which have provided for expanded leverage and added liquidity in the markets, have now caught the attention of policymakers as potential catalyst to a major market crisis.

This is one of the major issues taken up in the Davos Switzerland, where Zhu Min, the Bank of China's executive vice-president warned (emphasis mine), ``There is money everywhere. You can get liquidity from the market every second for anything. Derivatives are eight times global GDP and much of the money is flowing to Asia, where people have no idea what risks they are taking."

Figure 4: Lazlo Birinyi/ Trend Investor: S&P’s Record Run

As I have been saying along, despite fundamental risks, global markets appear to be getting ahead of themselves. In spite of Friday’s 3% decline, which shadowed the activities in Wall Street, the Phisix has still been up 6.04% year to date! And by virtue of being overextended, the market could simply tumble out of sheer profit-taking.

This observation from Steven Lord of the Trend Investor (emphasis mine), ``In a nutshell, this is the current situation in U.S. equity markets. Although I am not bearish on the market per se, the current bull market is elderly by historical standards at 51 months, while the S&P has now booked the 928 consecutive days without a one-day, 2% correction. It is the longest such streak since before the Depression, or, more correctly, for as far back as we can get daily prices. It is an ominous fact, since most things on Wall Street eventually revert to trend. With earnings and the economy decelerating, the Fed unlikely to be much help unless things dramatically change for the worse, and markets perched at record levels on the back of one of the longest bull markets on record, we’re calling the chances for a good, old-fashioned correction as better than good.”

Figure 5: Stockcharts.com: Emerging Market dissonance

In figure 5, one can see that emerging market debts (lower panel) appear to have “peaked out” and could be in the process of correcting, [via manifestations of lower highs and lower lows] while Emerging market bourses seems to continue with its upside momentum. However, the Morgan Stanley Emerging Market Index has yet to break the 925 hurdle to confirm its uptrend. Failure to do so could translate to a weakening momentum or a possible reversal.

Let me repeat, aside from all the negatives I’ve cited since (growing divergences, unfavorable market actions, fundamental, technical and sentiment risks), I think that our cost of capital have risen far more than the potential returns that can be gained from investing today, making the present day theme least attractive.

Say if one of the analyst is right on his prediction that the Phisix will gain 10% in 2007, with the Phisix already up 6%, this means your upside is now limited to 4% until the end of the year! But how about your downside risks? This is what I mean as the risk prospect has far outgrown your return potentials.

Of course, there will be selective opportunities within the market. We are after all in a long term bullmarket faced short-term risks.

Further, with eroding seasonal strengths, the manifestation of overconfidence through the bidding up of third tier issues signifies the accelerating speculative fervor. As such, it looks as if there are more fools or suckers out there than money to be made, which gives us another reason to be extremely cautious.

Yet, the market can still go higher predicated on a budding mania at work. As I have said to a favorite foreign client, acting on one’s portfolio reminds me of the Serenity Prayer which goes...

God grant me the serenity
to accept the things I cannot change;
courage to change the things I can;
and wisdom to know the difference.

There are things that we cannot change and things that we can act upon to effect changes for as long as we know our goals.

PLDT and A Resurgent Global Telecom Sector

Figure 6: stockcharts.com PLDT and Dow Jones World Telecom Index

Finally, this is just an observation; PLDT which today represents 18.87% of the Philippine benchmark index, has taken most of the load in driving the Phisix to its present level since 2003.

Yet in figure 6, the patterns of telecom issues worldwide, represented by the Dow Jones World Telecoms Index (line chart) and PLDT has been growing its correlation since 2006.

While I may be guilty of clustering illusions or seeing patterns when none exists, I think that following the tech bubble implosion in 2000 which included the telecom sector, the resurgent money flows towards the telecoms issues globally has further increased the global investor’s attention towards the Phisix’s major component.

A resurgent global telecom sector should constitute a significant impetus for local and regional telecom issues overtime.

Financial Globalization and Not Elections Will Determine the Path of the Phisix

``The whole aim of practical politics is to keep the populace alarmed -- and hence clamorous to be led to safety -- by menacing it with an endless series of hobgoblins, all of them imaginary.”—Henry Luis Mencken (1880-1956), prominent journalist

Almost everyone I talk to still believe that today’s market has been “local” driven in spite of the voluminous material evidence to the contrary.

In fact, I observed that in quite a significant number of comments, the upcoming election poses as a big factor of influence to the present activities in the market.

While I do not dispute that the forthcoming elections may have to some degree some influence, I do not think that it would be substantial enough to cause a ripple.

Recent events point to this:

In 2003, the Phisix climbed amidst a failed July coup which would have unnerved investor sentiment as in the 1987 and 1989 experience [see last week’s No Trend Goes in a Straight Line].

In 2004, the Phisix ignored the menace of political instability brought about by the rancorous contest for the chief of the land.

The Garci Scandal in 2005 managed to delay but was unable to wholly disrupt the ascension of the Phisix.

Simply put, the Phisix survived the most mephitic of the political environment on continued support from foreign capital flows. Foreign money remain as crucial determinants to the progress of the Phisix or to the Philippine asset class which seem to have been desensitized from domestic politics and much driven by “financial globalization” among other variables. Political tumults as in the case of Sri Lanka, Nigeria or Israel have not prevented global investors from bidding up local share prices as evidenced by their national benchmarks.

Unless political developments would have an impact on the capital flow framework as that of Venezuela or Thailand, they are unlikely to MATERIALLY affect the capital flow dynamics on our financial asset markets today. Hence, under such premises, the political election like in the past will most likely be discounted.

Of course, once the temporary setback in the markets should occur, an event which I expect to happen anytime soon, contemporary analysts will jump into the conclusion that these have been politically driven. You can count on that.

Building Your Nest Egg’s Prudently

``If you know the enemy and know yourself, you need not fear the results of a hundred battles.”--Sun Tzu

Lately, I have been astounded by the plethora of ebullient treatment the Philippines has been getting from various foreign research outfits and institutions. Imagine such remarks the “number ONE choice in the Far East”! It gives me goose pimples and makes me ephemerally feel like I am in a living in a prime investment haven.

It also marks a HUGE turnabout in mass psychology; an exoneration on my behalf. Back in 2002, when I turned bullish on the Phisix, such “reversal” theme was met with profound and revolting cynicism. The Phisix, as the consensus have it, was condemned to perpetual damnation. Nobody even wanted to discuss the existence of the market. Yet it was the best buying opportunity.

The Sage of Omaha, the world’s best stock market investor, Mr. Warren Buffett was absolutely right when he said that we should be greedy when everyone was fearful, and fearful when everyone was greedy. 2002 had been essentially, the pinnacle of FEAR.

Today, while I remain structurally bullish over the LONG-TERM potential of Asia’s financial markets and economic outlook due to the “wonders of globalization” and technology enabled macro developments, I have been alarmed by the sense of snowballing attachment to the gains of “yesterday”.

What has been seen as today’s triumphs have been projected to extend way into the future, which effectively discounts the risk elements attendant to the “subterranean” developments in the global financial and economic system.

In a list of cognitive biases, this is what is known as the Impact bias, where people have the tendency to overestimate how long they will emotionally benefit from present conditions.

And manifestations of such emotional attachments I can pick up even in my recent communications. For instance, because of the gingerly overtones of my outlook, a dear friend reacted to my pitch in displeasure, decrying of the loss of potential income for one’s “nest eggs”.

Nest eggs are basically built on portfolio allocations, principally designed upon one’s risk profile. Like any other financial markets, stock market investing comes with cost-benefit tradeoffs, where returns are hardly ascertained with consistent certitude especially over the short-term. As baseball Hall of Fame awardee, the witty Lawrence Peter “Yogi” Berra once said ``Prediction is very difficult, especially if it's about the future."

To build on one’s nest eggs, invest only the amount you can afford to risk. To believe that financial markets operate in a risk-free environment will only subject you to massive financial losses, if not mental angst or trauma. Gains today may not be there tomorrow. Risks do exist and most of the time the worst risk resides within us. As investor Bernhard Mast warned, ``First of all, you have to protect yourself from yourself".

We can also learn from the core tenets of Buddhism, where in the Four Noble truths, the ``first cause of suffering is due to our attachment to sense pleasure or desire”. Desire for untrammeled financial gains or plain vanilla easy money is a certain recipe for suffering.

Nothing’s Worrying the Markets

``Nature has given enough to meet man’s need but not enough to meet man’s greed.”-Mahatma Gandhi

I’ve been asked if the strong correlation of US markets and the Phisix still exists. Well, Figure 1 should give us the answer....

Figure 1 stockcharts.com: Phisix, Dow Jones Industrials and Dow Jones World

Correlations may not signify causation as it may well just be coincidental. Yet under the premises of liquidity driven financial markets, the Phisix (red candle) could most likely be “influenced” by mainly the fate of US dollar among other variables, in as much as the latter’s association had been with the US equity markets, represented by the Dow Industrials (black line superimposed) or with the world markets as in the case of the Dow Jones World Index (line-lower panel).

According to the Financial Times, ``US investors bought a record volume of foreign assets in November amid fears of a weakening currency, according to official data released yesterday....The record net $39.1bn (€30bn, £19.8bn) US investors put into foreign assets reflected both fears about the dollar and broader trends, according to Rick MacDonald of ActionEconomics.”

In addition, today’s “globalization” phenomenon, the accelerating trend of the integration of the world’s capital markets greatly enabled by technology, trends towards deregulation and return-seeking behavior borne out of “surplus” capital, as shown in Figure 2, has enhanced this interdependence.

Figure 2: Economist: Global Gusher

As to its main sources of liquidity, the Economist.com explains (emphasis mine), ``First, average real interest rates in the developed world are still below their long-term average. Second, America's huge current-account deficit and the consequent build-up of foreign-exchange reserves by countries with external surpluses has also pumped vast quantities of dollars into the financial system. A large chunk of Asia's reserves and oil exporters' petrodollars have been used to buy American Treasury securities, thereby reducing bond yields. In turn, low bond-market returns have encouraged bigger inflows into higher yielding emerging-market bonds, equities and property, especially in Asia. Liquidity has been further boosted by the use of derivatives, and by carry trades.”

What this implies is that the policy dictates of today’s global central banks have churned out an explosive expansion “capital”. This why as I pointed out last week the world financial markets have massively outgrown GDP. Put differently, you have global banks collectively sowing the seeds of inflation, and these are being transmitted through different channels at varying degrees. As an example, you see them first in the inflation of global asset markets, then spilling over to producer-consumer prices and possibly or eventually to the labor market.

One measure of liquidity is known as the M3, a statistical monetary aggregate, which the US Federal Reserve has discontinued publishing since March of last year based on being “costly”. The M3 basically depicts of the pace of money and credit creation by the FED.

While it is one of the most helpful statistics in monitoring the activities of the FED, it does not completely reveal about the trends in monetary policy. We can use either the Bank Credit or the price of gold as alternative means of tracking such policies. Nonetheless, inflationary policies cannot be hidden from the market. It will eventually reflect upon the diminishing purchasing power of the currency unit which undertakes such policies.

Figure 3: Nowandfutures.com: M3 Reconstructed

The explosive growth of M3+Credit as reconstructed by Nowandfutures.com shown in Figure 3, buttressed by an equally noteworthy acceleration of its rate of change (green line). Could this be the reason why gold (up $7.8 over the week) holds steadfastly at its present levels in the face of a selloff in oil and other metals? One must remember that gold has been in a bull market not only priced in the US dollar but against all major currencies.

Long time favorite analyst of mine John Maudlin brought up a very interesting Christmas carol from American billionaire real estate entrepreneur Sam Zell entitled, “Capital Keeps Falling on My Head”, which was sang to the tune of “Raindrops Keeps Falling on My Head”. You may watch it at http://www.yieldsz.com.

Here is a piece of the song, ``What lies ahead: we're old -- the western world is aging, we'll need income from our pension funds, where's it coming from? The yields we see won't fuel no party... And there's one thing I know -- To get things back to normal it's a long haul that's global. Yields won't improve 'til growth soaks up this liquid freefall. Capital keeps raining on my head. So much is out there that the world is out of whack. When will we see balance back? It's gonna be a long time 'til returns meet expectations. We need to be prepared for slim annuities..."

Mr. Maudlin further comments (emphasis mine), ``“Nothing's worrying me," is how B.J. Thomas ends the original version. That ending keeps playing in my head. Investors cannot be worried by much to look at real estate at 22 times projected future earnings. Or emerging market debt at little more than what you get for US government debt. Yields on all manner of investments have been compressed. How? As Zell says, "Illiquid assets have been alchemized into currency in play competing for returns."

Yes, nothing seems to be worrying the markets today. Yet, Mr. Zell message has been in the same light as ours, but forgets to add that the world is getting deeply more leveraged as increasing amount and rate of leverage are being utilized to squeeze out additional returns.

Gillian Tett of the Financial Times points out of the rapidly accelerating growth trend of ‘Structured Finance’, particular in the Collateralized Debt Obligation (CDO) market, which according to him “could make anybody blink” (emphasis mine)...``According to data released by JPMorgan this week, total issuance of CDOs - repackaged portfolios of debt securities or debt derivatives - reached $503bn worldwide last year, 64 per cent up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005.”

In another article Mr. Tett relates of how “frighteningly” such leverage multiplies in today’s financial markets (emphasis mine), ``the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. "Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.”

In essence, today’s market conditions have been increasingly dependent on the continuity of rising asset prices in support of these hastening and deepening trends of liquidity generation via leveraging.

Liquidity has been basically self-reinforcing; the larger the increase in one’s portfolio value, the more the access to larger leverage in order to generate marginal returns. Since extensive competition has driven down returns, low returns necessitate the use of more leverage. And the cycle revolves.

Even as economic fundamentals depict of a prospective downshift, these have been taken to mean as “good” for the financial markets, as Central Banks have been expected to deliver their roles as “financers of last resort”.

Valuations, no matter how high, relative to historical standards have been considered as “cheap”.

Credit spreads between once known as “risky” investment classes and “risk-free” government backed Treasury benchmarks has narrowed to record levels, implying that the degree of risks variance among diverse assets classes has substantially diminished.

Volatility indices are at record lows, suggesting that the world has become less risky!

Any news, either good or bad, has been justified as “good”. It’s been a “Brave New World” of highly leveraged asset-based economies out there! It has also basically been a high-risk low-return approach, where rampant speculation rules!

All these are manifestations of the outgrowth from the inflationary policies thrown to us by global central banks. As the leverage mounts, the risks become increasingly systemic. The world has never encountered such degree of leverage, and exploding growth in innovative financial instruments has not been stress tested.

We could never size up the potential scenario arising from the possible unwinding of this ‘house of cards’. It could be a combination of “debt deflation” and collapse of the faith based paper money system. Unless of course, a miracle occurs and economic growth upends the amount leverage in the system.

So far, the world financial system appears to have the capacity and room to absorb all these yet. Party on!

No Trend Goes In A Straight Line!

``Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting.” Jesse Livermore

As I’ve noted in the past, markets are mainly emotionally driven, despite the thought that we act rationally in its face, the painful truth is...we don’t. Since markets are hardly about equilibrium, as they constantly change, expectations can be overestimated in the short run and underestimated over the long run. In short, nothing is fixed everything is fluid and dynamic, governed by expectations.

Irrationality means that we are hardwired to frequently use “rules of thumb” or mental short-cuts in our thought processes particularly in decision making, often falling into traps of cognitive biases. Recency or Anchoring biases, overconfidence, rationalization, framing, loss aversion, regret theory are part of such “cognitive illusions” or the illusions of knowing.

There is also the phenomenon called as the “emergence”. Josh Wolfe of Forbes describes it as, ``Emergence is a fancy way of saying that the whole is greater than the some of the parts. Ant colonies, brains, cities, behavior in markets all exhibit this phenomenon of emergence where the constituent components give rise to higher order.” Put differently once we attain a certain level we tend to seek more.

And seeking more is what news headlines are all about these days as analysts pile atop each other declaring the bullish outlook for the Phisix “Philippines one of Asia’s top 3 investment sites” or “Stock prices seen rising further in ’07”.

As I have said in the past, market tops are usually characterized by “euphoria” and global markets including the Phisix could go vertical or parabolic before “topping out”. Let make a recent example of Saudi Arabia’s Tadawul All share index as shown in Figure 4.

Figure 4: Bloomberg: Saudi Arabia’s Tadawul All Share Index

As you can see in the chart, the final phase or “blow out top” of the Tadawul Index was marked by a nearly 90° ascent.

From about 2,500 to a little over 20,000, the Tadawul index leapt by nearly 7 times in three years before the harrowing collapse of late. Today, it drifts at around the 7,000 levels which essentially translate to over 60% of losses from the peak, in spite of the supposed intervention by Saudi’s Prince Alwaleed bin Talal. The scale of correction is almost equal and opposite to the degree of the trend that preceded it. The Lesson: The higher and the faster the rise, the steeper and harder the fall.

Of course, the structural dynamics of Saudi’s Tadawul is starkly different than the Phisix, of which the latter has followed closely the movements of major Global indices. Another is that the pace of volatility has not been as dramatic as that of Saudi’s bourse which had only 78 issues of publicly listed companies. Lastly, the financial market dynamics has been more “regional” oriented, the Phisix and Philippine asset class in general has had more correlation with the financial asset classes of its neighbors.

This is not to even suggest that the Phisix will do a Tadawul. The lessons are clear no trend goes in a straight line. Even the Philippine cycle shows the same patterns.

During the Phisix’s last bullmarket cycle which was from 1986 until 1997, the Philippine benchmark encountered two major mid-cycle corrections, triggered by the failed coup attempts of 1987 and 1989 as shown in Figure 5 (arrows).

Figure 5: Phisix: Reviewing the Last Bull cycle

Yes, the Phisix flew by over 10 (read my lips T-E-N!) times before the massive correction took place in 1987. And in both instances, the Phisix gave up over 50% of its gains during these mid-cycle retracements which lasted by about a year each.

As stated above, market trend dynamics are never linear.

Today, the Phisix has gained by only about 200% from its low in 2002, which makes its current advances relatively inferior compared to the Tadawul and Phisix 1986 experience to merit the same degree of horrifying adjustments.

In other words, if the Phisix should correct in tandem with global markets, I do not expect the same extent of damage seen in our previous examples.

Figure 6: Phisix subsectors: Mines Diverge

As for industry specifics, if one where to assess on the recent actions of the market, the mines and the general market moved independently of each other in 2006, which makes a worthwhile case for portfolio diversification, see Figure 6.

The mining index (orange line) took the first semester by storm, while severely underperforming the second semester rally by a big margin against the broadmarket issues.

This means that while it is possible for mines to diverge with the general market even when the PHISIX corrects, given the narrow breadth of our underdeveloped market, the opposite case of the rising tide lifts all boats could also occur. As Edwin Lefevre wrote, ``In a bull market, all stocks go up. In a bear market all stocks go down...in a general sense.” I think this applies especially to less advanced and sophisticated markets as ours.

Well, candidly, I wouldn’t exactly know how the market would turnout when a correction transpires. Sorry, but I have no predictive powers of a clairvoyant, unlike some of my contemporaries. Instead, I heed the advices of the battletested and successful investment or fund managers as the legendary John Templeton, who said ``The best time to invest is when you have money. This is because history suggests it is not timing which matters, it is time.”

And based on time, in the context of market cycles and probabilities, since I think we are in a secular long term bullmarket, positioning gradually based on how the market progresses or how the interim cyclicality unfold should make one’s returns at least at par with the index.

Over the short-term, I think the Phisix as well as most global markets are in high-risk low-return sphere. I would rather be cautious and selective. Be careful out there.

Global Risks Rise Amidst Market Euphoria

``There are a terrible lot of lies going around the world, and the worst of it is half of them are true.” Winston Churchill

FORECASTING markets, particularly over the short-term, is an incorrigibly tricky pursuit. Variable gyrations and wildly random pendulum swings characterizes the market’s volatility whose directions over the short term are as good as a “throw of dice”. Curtly said, your guess is as good as mine. In the words of Benoit Mandlebrot, author of the Misbehavior of Markets, ``All is not hopeless. Markets are turbulent, deceptive, prone to bubbles, infested by false trends. It may well be that you cannot forecast prices. But evaluating risk is another matter entirely.”

And risk evaluation and assessment is what distinguishes us from the rest of the domestic playing field, simply because our paramount aim has been to preserve capital, aside from maximizing profit opportunities and containing losses.

Of course, we try to heed on Warren Buffett’s invaluable advice of reading and applying on Ben Graham or Phil Fisher’s principles in relation to the “macro” stuffs, and don’t engage in equations with “Greek” letters on them, especially on “technical grounds” as some others do.

Figure 1: Guardian: World Economic Forum: Complex and Interconnected Global Risk Environment

I have interminably argued that today’s market landscape has dramatically shifted, such that the “Globalization” platform phenomenon backed by the “technological telecommunication and information revolution” has tremendously increased the interconnectedness or the correlations of our market’s movements with that of the world’s. In doing so, our domestic market have now been subjected to the ebbs and flows of global capital, sharing with it, as much of its benefits, the risks of an “increasingly complex and turbulent complex world” as shown in Figure 1.

Notes the World Economic Forum in their Global Risks 2007 (emphasis mine) ``In an increasingly complex and interconnected global environment, risks can no longer be contained within geographical or system boundaries. No one company, industry or state can successfully understand and mitigate global risks.”

All this goes to show that for as long as the world continues on its path towards the evolution of greater economic and financial interdependence, its markets, business environments, national and macro economies, aside from political, social and cultural dimensions are likely to evolve towards encompassing more developmental convergences, relative to risks and benefits.

With no less than the recent ASEAN meeting in held in our Cebu to corroborate on this perspective, according to China’s Xinhua/People’s Daily Online (emphasis mine), ``In the signed document, ASEAN leaders reiterated their conviction that "an ASEAN Charter will serve as a firm foundation in achieving one ASEAN Community by providing an enhanced institutional framework as well as conferring a legal personality to ASEAN."

Figure 2: McKinsey Global Institute: Record Cross-border Capital Flows

In addition, as testament to a world of greater integration, global capital flows have reached record levels where the Compounded Average Growth Rate (CAGR) has steepened to an average of 10.7% per annum during the last 15 years compared to 4.3% during 1980 to 1990 period, as shown in Figure 2, where in such environs the emergence of the global investors class has evolved.

In its 3^rd Annual Report, McKinsey Global Institute, noted that (emphasis mine), ``In 2005, worldwide cross-border capital flows, which include foreign purchases of equity and debt securities, cross-border lending, and foreign direct investment (FDI), increased to more than $6 trillion, the highest level ever. Since 1990, cross-border capital flows have grown 10.7 percent annually,10 outpacing growth in world GDP (3.5 percent), trade (5.8 percent), and financial stock (8.7 percent). Advances in technology and the deregulation of financial markets around the world have enabled this growth and given rise to a growing class of global investors. Although investors in most countries still show a marked preference for financial assets of their home country, roughly one in four debt securities and one in five equities today is owned by an investor outside the local issuing market—for instance, a US investor buying Thai equities, or a German investor buying US bonds. National financial markets are increasingly integrating into a single global market for capital.”

Plainly stated, much of the world’s developments matters for us today than the “wisdom of conventional thinking” would have it. To paraphrase New York Times’ columnist Thomas Friedman in his bestseller, the WORLD is indeed becoming FLAT.

For us, business or financial models or paradigms and market analysis would have to deal with the instrumentalities of present realities rather deluding ourselves of insularity.

To be get ahead of the curve, one has to learn how to adopt on the strategies or approaches underpinned by the present trends and risks, otherwise lose out to either obsolescence or competition.

Which brings us back to our risks analysis, the World Economic Forum (WEF) through their Global Risk Network identifies 23 global risks subdivided into the segments of economics, environment and geopolitics, The Guardian quotes the WEF warning (emphasis mine), ``Expert opinion suggests that levels of risk are rising in almost all of the 23 risks on which the Global Risk Network has been focused over the last year, but mechanisms in place to manage and mitigate risk at the level of businesses, government and global governance are inadequate."

The WEF enumerates the five major economic risks namely, an oil price shock, a plunge in the US dollar, a hard landing in China, budget crises caused by ageing populations and a crash in asset prices, which has been ``more acute than at this time last year”.

It also cited worsening instances of the four out of five environmental risks, particularly climate change, loss of fresh water supplies, tropical storms and inland flooding.

Aside from the incremental escalations in six geopolitical risk factors, specifically, international terrorism, WMD, war, failed states, instability in the Middle East and a retrenchment from globalisation. The WEF warns that if such factors tip into a degree of intractability, ``the environment for business and society could be changed beyond recognition."

True, today’s financial markets have been discounting much of these factors, in fact, the world equity markets appear to be exceedingly ebullient.

While some domestic technical “experts” have claimed in consonance to my view that today’s market has been quite overheated, following a semblance of retracement, the Phisix and the global markets rallied sharply at the end of the week which once again took queue from the actions in the US markets, despite the asymmetric or discordant signals from the broader financial markets (rallying US dollar and gold, declining bonds, copper and oil.) as shown in Figure 3.

Figure 3: ChartoftheDay.com: Dow Jones at Critical Juncture

Here chartoftheday.com says that while the Dow is in critical juncture following the string of record high closes amidst its astonishing climb in a backdrop of a litany worries, it has to yet hurdle its three-year trading channel to steer clear of technical obstacles, which incidentally could also prove to be its decisive bump.

Figure 4: Stockcharts.com: Phisix, Dow Ex-Japan Asia Index and the Morgan Stanley Emerging Free

However, if you take a gander at figure 4, the Dow Jones 1800 Ex-Japan Index (black line superimposed), a benchmark consisting of 1,800 companies throughout Asia, the Morgan Stanley Emerging Free Indices (black line lower panel), a benchmark of the broad universe of emerging markets “developing economies” benchmarks and the Philippine Phisix, the movements including short-term fluctuations have been almost similar to the extent that the recent retracements or even the “timing” at the end of the week rally appears to have been “orchestrated”. No conspiracy theory here, just a depiction of the congruity by global markets.

And to consider the Philippine setting, today’s market activities have been envisaged by massive outperformances of companies with little fundamentals. Formerly dormant companies with little or no operations have been taking the centerstage accruing mouth-salivating gains that have been attributed to corporate stories of potential backdoor listings, Mergers & Acquisitions and/or plain vanilla “push” by certain interest groups.

The recent easy gains have ostensibly lured vulnerable retail investors, the last among the investing group to get involved, to undertake aggressive moves in the broader market.

Such conspicuous froth have been simply reflective of an outgrowth of an accelerating speculative mindset, where one could even hear arguments stating that “nothing in the local arena poses as significant threat to present conditions”.

Markets Make Opinion

``The Masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduce them. Whoever can supply them with illusions is easily their master; whoever attempts to destroy their illusion is always their victim.” -Gustave Le Bon, The Crowd

As we have noted last week, “Markets make Opinion”, where “experts” and journalists in complicity draw up to form what is known as the “conventional wisdom”, a simplified explanation for market causalities.

First, the public including local mainstream experts have the tendency to be guided by the “recency bias” or the “rear view mirror” or “anchoring” syndrome, where they extrapolate the most recent past and project them into the future.

Second, the lack of perspective, our experts have been inclined to cite whatever headlines in order justify today’s market’s action. In behavioral finance, such is called “rationalization”.

Third, as we noted last week, it’s all about incentives; the merrier the market, the appearance of a more risk-free environment encourages “experts” to amplify the short-term risk appetites of the average investors.

Yet flurries of short-term trades or overtrading are manifestations of the folly of overconfidence; one of the major reasons why the average investors are left to hold the proverbial empty bag when the cycle reverses.

Nonetheless, such pressures for short-term gains come irrespective of potential risks. Typical brokers encourage investors towards more technical approach to the market, in order to whet their appetites for greater turnovers.

Anyway, Figure 5 is a chart from the normally Panglossian research outfit, the Taipan group which dissects upon the effects of an economic slowdown combined with a declining trend of corporate earnings in the US to the possible performance of US markets in 2007.

Figure 5: Taipan Group: The Coming Earnings Crunch

Let me quote Steven Lord, editor of the Trend Investor of the Taipan Group (emphasis mine), ``The above chart, tracking the earnings of the S&P 500 since the middle of 2003 and applying estimates through the third quarter of 2007 from Thomson Financial, shows the steady decline in year-over-year percentage gains. Companies in the S&P have expanded earnings at a double-digit pace for the last 13 consecutive quarters -- or for the last three years....This leaves the stock market, perched as it is close to record levels, with only one way to move higher -- multiples have to expand. In other words, for stocks to rise significantly from here investors will have to pay “more” for a dollar of earnings in 2007 than they did in 2006, via a re-rating of the market’s overall P/E ratio. With earnings trending down and the economy slowing, awarding a higher P/E ratio is the only way for the market to rise from here. While not impossible -- at roughly 15, the market is hardly overvalued on a P/E basis -- it is clearly a higher risk strategy than we have seen for the past few years.”

Higher price multiple implies for richer valuations which makes today’s approach to the equities market clearly a higher risk strategy as Mr. Lord warns. Yet momentum remains tilted towards an acceleration of prices regardless of economic realities, where multiples could even reach bubble-like proportions as in 2000.

Markets can stay irrational longer than you can remain solvent says the illustrious economist John Maynard Keynes. Yes, today’s market environment may even surprise hard-core technicians that prevailing euphoric sentiments could lead to parabolic or sharply vertical moves; a speculative blowoff top in spite of present risks.

Considering the high-risk proposition of today’s market climate, it is probably best to simply keep your present positions and avoid overtrading and anteing up heavily by chasing prices.

Since the market has palpably been rotating it would be of lesser risk to employ risk capital to issues that have lagged, and hope for a contagion, i.e. if the itch to join the bandwagon trade becomes irresistible. Here position sizing greatly matters.

Moreover, one must keep in mind the basic market tenet that NO TREND GOES IN A STRAIGHT LINE. Such that while I remain bullish with the SECULAR or long term trend cycle of the Phisix, current conditions have raised the risk profile for investors to warrant a more cautious approach to the market.

It is also recommended or advisable to employ the practice of TIGHTENING of your STOPS in case the market does unwind. Remember, the steeper the market climbs, the harder its potential fall.

Unifying Global Stock Markets; Asia Looks Next!

``Over the next three to five years, we will become global and more diversified. The next logical spot is Asia. At some point we want a position in the Chinese market and in the Indian market."--John Thain, CEO of The NYSE Group

In its 3^rd annual report the McKinsey Global Institute estimates that the Global Capital markets-equity securities, private and government debt securities and bank deposits reached US$ 140 trillion in 2005 representing about 316% of the Global GDP as shown in Figure 6.

Figure 6: McKinsey Global Institute: 2005 Global Financial Assets

Global equities which accounted for about 31% of the financial pie contributed the most growth among these assets in 2005, according to McKinsey, ``Equities accounted for nearly half of growth in global financial assets in 2005, increasing by $7.1 trillion. Although Japan had the largest single gain in equity markets, with an increase of $1.5 trillion, equities’ growth was broad-based. The eurozone saw its stock of equities increase by $1.2 trillion; the United States by $650 billion; and the United Kingdom by $550 billion. Equities also accounted for more than half of emerging markets’ growth in financial assets—with growth of $2.2 trillion.”

As global equities are expected to reach $59 trillion in 2010, the race towards the industry’s consolidation has apparently intensified.

At the end of 2006, two major stock exchanges, the New York Stock Exchange (NYSE), the world’s largest stock exchange in US dollar terms and the Euronext- Continental Europe’s largest bourse which runs Paris, Armsterdam and Lisbon, obtained the respective approval by their shareholders to a merger of giants. Last week, the European regulators formalized the approval of the US$15 billion merger.

Following the failed takeover offer by the Macquarie Bank, the London Stock Exchange (LSE) received a bid by NYSE’s key rival, the NASDAQ in March of 2006. As the NASDAQ negotiated its way through the takeover deal, it worked to accumulate LSE shares, which today accounts for a hefty 28.75% of England’s bourse. Having been spurned twice, NASDAQ’s active offer remains in abeyance even as the LSE options dissipate following the finalization of the NYSE-Euronext merger and Deutsche Börse withdrawal from the bidding contest. A resolution to this takeover offer could be realized this year with a growing likelihood of its completion.

Even in the futures market we are witnessing the same thrust: In 2006 the Chicago Mercantile Exchange (CME) proposed to acquire Chicago Board of Trade (CBOT) that would create the world’s largest futures exchange in a deal worth about $8 billion. Presently awaiting regulatory approval and the endorsement from the shareholders the merger is likewise expected be completed by 2007.

With the revolutionary advances in the field of communications and information technology-the advent of on-line electronic trading platforms makes it possible for real-time electronic transactions regardless of the geographical distance.

Grounded on this premise, the major exchanges appears to be in a rush to integrate financial services, to diversify and expand their market coverage, reduce transaction (bookkeeping, clearing and settlement) costs by achieving the economies of scale, to eliminate further inefficiencies by way of human intervention, provide for financial depth by attracting global investors (to augment the demand side), traders and listing companies (to increase supply side), to improve on liquidity by easily matching buyers and sellers, and finally, adapt to the ongoing changes in marketplace by being accessible to the growing significance of institutional investors [pension funds, hedge funds, mutual funds and insurance companies] as compared to retail investors in the past.

With the global trade and economic structure presently favoring Asia, as evidenced by its exploding foreign exchange reserves and rapidly rising per capita and middle class, its largely fragmented and underdeveloped financial markets makes it a potential ground for an explosive expansion. According to McKinsey Global, ``Perhaps more surprising is the fact that Asian countries have the largest links not with Japan or Hong Kong, but with the United States, the United Kingdom, and the eurozone, underscoring the lack of an integrated Asian financial market.”

Under such vein, NYSE’s CEO John Thain said in an interview last December at CBS that Asia “is the next logical step” for expansion. Mr. Thain opines that demutualization as prerequisite prior to any possible alliances (instead of acquisitions), and that entities will be “kept separate with no regulatory crossovers”. Mr. Thain was said to be eyeing Japan, China and India.

At the onset of 2007, NYSE’s Mr. Thain wasted no time into taking concrete action with his plans. In a rapid fire succession, he recently stitched up an alliance with Tokyo, joined a team of investors which included investment bank Goldman Sachs and private equity firm General Atlantic to acquire 20% of the India’s largest stock exchange the Mumbai based National Stock Exchange and even Australia’s ASX caught up on the speculative excitement as the next potential deal for NYSE. On Friday, the Australian Stock Exchange jumped 4.5%.

Today, the Philippine Stock Exchange, despite its miniscule capitalization and traded volume relative to global standards or its peers, will be an inescapable part of the ongoing global trends to unify financial market exchanges, such that in the future it will a party to any potential alliances, or consolidations by mergers or acquisitions, as well as, take into account the realization of cross-border listings, after progress on regulatory hurdles would have been met and expanding trading facilities to possibly include other asset markets.

In the future, you and I would be able to possibly trade US, European or any neighboring countries stock listings that could be accessed by the local trading platform at our very homes.

All these will not happen overnight but is part of the ongoing seismic shift in the financial realm. This is just one of the many steps towards the Phisix 10,000!