Parties Never Last, Hangovers Do!

``The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”- Warren Buffett

The risks remain out there in spite of the snowballing sanguine expectations.

Figure 2: IMF: Philippine Peso and the VIX Index

In figure 2, courtesy of the IMF, the Philippine Peso (dotted line) has appreciated amidst the backdrop of a RECORD low volatility, low signs of anxiety and high-risk appetite conditions as represented by the VIX Index.

Figure 3: IMF: Appreciation pf Regional Currencies Against the US Dollar

And as I have likewise pointed out in the past, the rising Peso has been a regional phenomenon as shown in Figure 3, again from the IMF. Growth in forex reserve surpluses, increasing rate of (portfolio) investment flows, surging remittances, greater official cooperation, regionalization trends and/or increased economic and financial integration have served as the key impetus, aside from of course, as beneficiary to the global carry trade and a structurally weakening US dollar.

Figure 4: IMF: Rollover and Exchange Risks in Public Debt

The Philippine financial markets seems to be pricing in conditions where the low key reporter Clark Kent turns himself into Superman! Yet, all these could be illusory or smoke and mirrors as global inflationary policies heavily distort risk pricing activities by investors whose goal had been no less than to hunt for expanded returns, no matter the risks involved.

While there is no question that the present efforts of reforms instituted by the incumbent administration has significantly improved the country’s finances and fiscal position, a boatload of work remains to be done.

In Figure 4, the IMF reminds us that the Philippines remains as the region’s MOST VULNERABLE relative to Debt to GDP risk, Exchange Rate risk and Rollover exposed debt to GDP. Wrote the IMF (emphasis mine), ``As a result of recent reforms continued robust growth, and the more appreciated exchange rate, staff expect NFPS (Non-Financial Public Sector) debt to have fallen below 80 percent of GDP by end-2006, compared to 100 percent at end-2003. External debt is expected to have declined by a similar order of magnitude. Nonetheless, the Philippines remains vulnerable to a sudden reversal in global risk appetite, as rollover and exchange risk remain high.”

And this is what I’ve been saying all along. Today’s tsunami of capital has prompted both the private and public institutions, particularly the emerging trend of state investment companies to manage excess reserves, into expand their investing universe, to even consider illiquid and exotic themes, in order to squeeze out returns in a world faced with diminishing returns due to extensive competition and adaptation of similar investing approaches.

Furthermore, the introduction of innovative instruments such as derivatives, structured products and other forms of sophisticated trading strategies has compounded this outlook. As we have discussed before, in order to expand returns more leverage are being applied to magnify returns.

For instance, in our past issues we delved about the added liquidity brought about by the provisions of the carry trade arbitrage, where according to the Financial Times, ``households in Latvia and Romania have developed so much enthusiasm for borrowing in yen.” This means the carry trade has now turned increasingly global and more widespread to include unsophisticated households.

As record short positions have been taken against the “funding” currencies of the Japanese Yen and the Swiss Franc, demand for high yield instruments as the New Zealand’s dollar have caused a surge in the bond issuance of KIWI, adds Peter Garnham, Gillian Tett and David Turner of the Financial Times (emphasis mine), ``To take one out-of-the-way corner of global finance, the amount of bonds denominated in New Zealand dollars by European and Asian issuers has almost quadrupled in the past couple of years to record highs. This NZ$55bn (US$38bn, £19bn, €29bn) mountain of so-called "eurokiwi" and "uridashi" bonds towers over the country's NZ$39bn gross domestic product - a pattern that is unusual in global markets.” Incredible.

While this has so far reduced the volatility in New Zealand’s currency or any asset beneficiaries of the carry trade by way of offsetting the risks via hedging through derivatives, the world has been consistently adding tremendous amount of leverage which may at one point pose as a systemic risk or destabilize the global financial markets and the world economy.

Derivative trades, like any typical trades work on two ways, a buyer and seller, while such aims to reduce risks by dispersion one thing we shouldn’t forget is that there is always someone on the other side who will absorb the risks.

And I think this phenomenon is adding to the speculative inflows into our region and our local asset class.

Table 1: Guinness Atkinson’s Asia Brief: Asia’s PE

Aside from China and Hong Kong which had been mentioned earlier, on a year to date basis here is how the region fared: New Zealand +3.07%, Australia +5%, Taiwan -1.82%, South Korea +1.0%, Thailand +1.2%, Indonesia -.62%, Japan/Nikkei +3.77%, Singapore +8.4% and Malaysia +15.13%.

As you can see in Table 1, relative to PE ratios, the Phisix is situated on the HIGH end among its regional contemporaries in 2006. Whereas its earnings growth is expected to outperform the region for 2007 and 2008, the present gains appear to have almost consumed the expected growth rate. The same dynamics can be said of with the outperformance of Malaysia and Singapore, as well as, China. This essentially means that today’s star performers appear to be more richly valued relative to its peers.

Like your analyst, the Guinness Atkinson team remains bullish on Asian assets over the long term where they noted that (emphasis mine) `` it is the outlook for Asia’s domestic demand that is a key issue for future investment prospects and strategy. It also helps us understand why Asian central banks have been reluctant to allow too rapid a rise in their currencies while local demand remains fragile. Inflation in the region is subdued (including Indonesia where it has fallen sharply in the last couple of months to 6.6%) and should remain so until domestic demand picks up.”

Figure 4: Daily Wealth: Emerging Markets as Expensive as Ever!

Finally in figure 4, Daily Wealth Dr Steve Sjuggerud thinks that emerging market stocks are overbought, overvalued and way extended after having breached twice the Book Value of its underlying assets.

In other words, as our markets continue to head higher, the risks of sharper adjustments by way of precipitate correction increases. Parties never last, hangovers do.

Interview on CNBC with Warren Buffet and My Comments

``Wall Street likes to characterize the proliferation of frenzied financial games as a sophisticated, prosocial activity, facilitating the fine-tuning of a complex economy. But the truth is otherwise: Short-term transactions frequently act as an invisible foot, kicking society in the shins." - Warren Buffett

I’d like to thank my pal Raul Policarpio for passing on to me this very interesting subject, a summary of the life of the world’s second richest man....

There was a one hour interview on CNBC with Warren Buffet, the second richest man who has donated $31 billion to charity. Here are some very interesting aspects of his life:

1) He bought his first share at age 11 and he now regrets that he started too late!

2) He bought a small farm at age 14 with savings from delivering newspapers.

3) He still lives in the same small 3 bedroom house in mid-town Omaha, that he bought after he got married 50 years ago. He says that he has everything he needs in that house. His house does not have a wall or a fence.

4) He drives his own car everywhere and does not have a driver or security people around him.

5) He never travels by private jet, although he owns the world’s largest private jet company.

6) His company, Berkshire Hathaway, owns 63 companies. He writes only one letter each year to the CEOs of these companies, giving them goals for the year. He never holds meetings or calls them on a regular basis.

7) He has given his CEO’s only two rules. Rule number 1: do not lose any of your share holder’s money. Rule number 2: Do not forget rule number 1.

8) He does not socialize with the high society crowd. His past time after he gets home is to make himself some pop corn and watch television.

9) Bill Gates, the world’s richest man met him for the first time only 5 years ago. Bill Gates did not think he had anything in common with Warren Buffet. So he had scheduled his meeting only for half hour. But when Gates met him, the meeting lasted for ten hours and Bill Gates became a devotee of Warren Buffett.

10) Warren Buffet does not carry a cell phone, nor has a computer on his desk.

11) His advice to young people: Stay away from credit cards and invest in yourself.

***

While I do not know about the authenticity of this article I would like to share my insights on this interview:

1. My icon shows of a regimented way of living which reflects on his investing philosophy.

2. His aversion to credit cards is a sign of discipline. Why pay for the financing charges on unproductive expenditures?

3. While he may not be as sociable by way of avoiding the high society crowd, his contribution to the investing world, his invaluable shared insights makes him one of the world’s well respected and greatly admired persons.

In 2006, a lunch date auction with Mr. Buffett for charity purposes raised US $620,000. In other words, one person shelled out US $620,000 (€341,000) just to have lunch with him! Would anyone pay for the same amount to have lunch with any of the other members of the “high society” crowd?

Further as stated above, Bill Gates became a devotee or protégé of Warren Buffett, to the point that Mr. Gates is now a board of director in Mr. Buffett’s flagship Berkshire Hathaway and a beneficiary of Mr. Buffett’s $37 billion donation to the Gates Foundation.

Could it be that winning the respect of the world’s richest man is considerably worth more than that of the “high society crowd”?

4. It is the embodiment of Humility at its finest!

5. Mr. Buffett loves Coke [drinks five cherry cokes a day (!) according to CNN], his Berkshire Hathaway is Coke’s second largest shareholder according to fundinguniverse.com!

6. Mr. Buffett loves to play Poker [so does Mr. Gates]! The Billionaire recently went BROKE in a Texas charity tournament last December, according to MSNBC.

Do you have what it takes to emulate Mr. Buffett? I don’t.

SubPrime Jitters and the LUDIC Fallacy

``Fools ignore complexity," said Alan Perlis, the US computer scientist, "Pragmatists suffer it. Some can avoid it. Geniuses remove it." The world's central bankers, who are fretting about the growing complexity of financial markets, are clearly not fools. But unless a genius comes along with a solution, they will have to be pragmatic about complexity, and all of the risks that it entails.”-Financial Times, Where is the Risk?

I had been asked by a client if the recent developments in the US subprime mortgages market could signify as a possible catalyst that could upset the present momentum in the financial markets.

Subprime loans are basically loans to consumers who do not qualify for prime rate loans and have impaired or non-existent credit histories, therefore are classified as a higher risk group likely to default. As such, subprime loans are charged at higher rates compared to the prime loans.

``They made up about a fifth of all new mortgages last year and about 13.5 percent of outstanding home loans, up from about 2.5 percent in 1998, according to the Washington-based Mortgage Bankers Association” notes a Bloomberg report.

Rising incidences of defaults and foreclosures have led to a wave of mortgage lenders going under. Since December of 2006 ``about 20 lenders have gone kaput”, according to Mortgage-Lender-Implode-A-Meter.

Present developments have likewise led to the an increased loan loss provisions by the world’s third largest bank by market value, the HSBC Holdings Plc, aside from suffering from a management shakeout, while US second largest subprime lender New Century Financial Corp said that it probably lost money last year and had to restate earnings for 2006, where its stock prices tumbled 36% last Wednesday.

While of course we remain vigilant over the fact that the latest housing boom in the US has been the biggest since 1890, according to Yale Professor Robert Shiller of the “Irrational Exuberance” fame as shown in Figure 1.

Figure 1: NYT: Largest Housing Boom Since 1890

The consequent fallout could rather be nasty. As we previously quoted Mr. Shiller [see Jan22to 26 Financial Globalization’s Pluses and Minuses] saying that while the present decline in the housing industry had been seen largely in the context of the RATE of change by mainstream analysts, nominal housing prices remain at LOFTY levels. And at such high levels, it would be unusual for a manifestation of a bottom as activities remain vibrant aside from indications that the bulls remain HOPEFUL.

Since ALL markets are essentially psychological, the embellished description by the elaborate Josh Wolfe of Forbes on the US present day housing dilemma seems clear enough, ``But it’s not until you see a middle-class family on the cover of Newsweek with their bags outside of a church that we’ve seen full capitulation. Like a pendulum, when things go to excess they revert.”

Mr. Shiller recently twitted mainstream analysts in his latest commentary at the Wall Street Journal for not being able to predict the occurrence of the recent US housing boom, and as consequently questions them for their ability in finding a bottom, yet he wrote to remind us that the present risks shouldn’t be papered over (emphasis mine),

``We are left with a deeply uncertain situation, but one in which it would seem that a sequence of price declines continuing for many years has some substantial probability of happening. Traditional finance theory has trouble reconciling even a semi-predictable sequence of price declines with basic notions of market efficiency. The situation we are facing is a reminder of the glaring inefficiencies and incompleteness of existing markets for residential real estate, and may be regarded as evidence that institutional changes will be coming in future years to fundamentally change the nature of these markets.”

Let me remind our readers that today’s Globalization has NOT been limited to trade and migratory trends but also to the financial markets.

Figure 2: Stockcharts.com: Global Correlation

Where money flows have been enabled by the click of the mouse, and where global inflationary policies, which have resulted to an ocean of liquidity, have collectively altered the risk environment as evidenced by record low spreads and interest rates, almost simultaneous advances in diversified asset classes, historically low volatility and strong risk-taking appetite; the world’s financial market have shown unprecedented correlativeness.

As evidence, look no further and compare our own Phisix (red-black candle) in Figure 2, with that of the Dow Jones Industrial Averages (black line), and the Ishares MSCI Emerging Market Index (lower panel). Quite simply, world markets appears to have moved as one, which suggests that as much as the present market gains from the dynamics of global interrelatedness, the fundamental risks have been equally shared, as we have explained in our January 8 to 12 edition (see Global Risks Rise Amidst Market Euphoria).

To quote the recent Emerging Market Report by the Institute of International Finance or the world’s only global association of financial institutions (emphasis mine), ``There are a number of risks to the projections. They include: increasing geopolitical tensions with potential effects not only on the real economy but also on market sentiment and risk appetite; uncertainties about the duration and severity of the ongoing housing slump in the United States as well as its impact on the rest of the economy; and the ever-present potential of the huge global current account imbalances igniting a disorderly adjustment, especially in the event of a sharp weakening in U.S. growth. Realization of any of these and other major risks could bring about a sharp adverse turn in the global financial environment now characterized by ample liquidity, low volatility, and strong risk appetite.”

Going back to whether the spate of adverse developments in the US will spillover to its financial markets and spread globally, recent market actions tell us that such effects have been rather benign or subdued, so far.

Figure 3: Stockcharts.com: Dow Jones Mortgage Finance and Philadelphia Bank

In Figure 3, the Dow Jones US Mortgage Finance Index (red-black line), whose components include the Government Sponsored Enterprises (GSE) as Freddie Mac and Fannie Mae, aside from the Philadelphia Bank Index (black line) has apparently shown minimal collateral damage arising from the recent developments.

Considering that the present state of the markets which has been largely overbought and overextended, the recent activities merely reflect profit-taking instead of a PANIC driven strain of action. Put differently, the damage has not been MATERIAL enough to convincingly manifest of a TREND REVERSAL.

There are two important matters to distinguish here; one is a plain correction which simply implies profit taking but a continuation of the underlying general trend and the other is an inflection point which indicates of a general trend reversal. Taking on the necessary action depending on which circumstances emerge is very important in determining your portfolio returns.

Investors who rely mainly on the assumption of fundamentals as drivers to the markets, ignoring market psychology, could get surprised or stumped with losses by the extraordinary resilience of a trend. In the words of market savant billionaire philanthropist George Soros in his book, the Alchemy of Finance, ``Markets are almost always wrong but their bias is validated during both the self-fulfilling and the self-defeating phases of boom/bust sequences. Only at inflection points is the prevailing bias proven wrong.” This goes to show that even if the markets are deemed fundamentally wrong they may remain or stay wrong until a certain point. Or as marquee economist John Maynard Keynes once warned, ``the market can stay irrational longer than you can remain solvent.”

Yes, defying a trend can usually be hazardous to one’s portfolio.

As you know, I have remained skeptical of the present rally on largely the account of a general downshift in the global economy, as shown in Figure 4, whose ramifications are to a large extent unqualified and whose outcome could be uncertain.

Figure 4: IIF: Worldwide Economic Growth Slowdown

Unlike the consensus who believes that today’s financial markets looks insuperable, deservingly risk free and incorporates permanency to present conditions, the inflationary dynamics has, in my view, distorted the way risks have been priced in, in as much as how assets have been valued at.

Further, boom-bust cycles have been determined by massive credit expansions from which today’s marketplace have been structured, in the words of the illustrious Ludwig von Mises, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market”.

In principle, this makes little difference from what has occurred in the Great Depression in the 1930s to Japan’s recent bout with deflation. Of course, this is in sharp contrast to Milton Friedman-Anna Schwartz’s theory [US Fed Chief Bernanke’s icon] that it was government’s failure to liquefy the system that caused such conditions.

In fact, in terms of the scale and magnitude, today’s money and credit creation has been unprecedented.

I might add too that today’s financial marketplace is undergoing the greatest experiment of all time, the FIAT MONEY Standard or the US dollar “DIGITAL and DERIVATIVES” standard system.

American Jurist Oliver Wendell Holmes Jr. once said that ``A page of history is worth a volume of logic.”

In the John Law 1720 experience, the excesses of fiat money dynamics caused a reversion to the gold standard; it may or may not be the case today. In human history ALL experiments with paper money have been etched in epitaphs.

The great depression led to the US Government’s revocation of the public’s ownership rights of gold and the adoption of protectionist policies.

In addition, while there have been indeed massive changes in today’s economic and financial frontiers such as a combination of deregulation, technology enabled integration, greater participation of nations to trade and the inclusion of a huge pool of labor supply into the world economy, which has contributed to what is known as the era of disinflation, the collective government/central bank’s action has been to sow the seeds of inflation in the financial system.

The public’s perception that inflation remains muted lies on the chicanery of price index manipulation meant to promote and preserve the political power of the ruling class, regardless of the form of government. In Zimbabwe, for example, its national government comically and laughably declared inflation as illegal amidst hyperinflation or inflation gone berserk! Quoting New York Times (emphasis mine), ``For the government, “the big problem about Zimbabwe is that the one thing you can’t rig is the economy,” said one Harare political analyst, who refused to be identified for fear of being persecuted. “When it fails, it fails. And that can have unpredictable effects.” Well, governments can rig anything except for purchasing power.

One must be reminded that these massive changes globally may well just be the initial impacts of the adjustments operating under a greatly expanded economic universe which should translate to rising inflationary pressures overtime as demographic trends and entitlement programs continue to exert pressures on the fiscal state of collective governments.

This is not without precedent, however. Historian Niall Ferguson identifies globalization trends prior to 1914 which ended with the advent of World War I. Operating almost in the same template, the financial markets had been equally complacent then and risk insensitive. Let me quote Mr. Ferguson at length,

``To be sure, structural changes may have served to dampen the bond market’s sensitivity to political risk. Even as the international economy seemed to be converging financially as a result of exchange rate alignment, market integration, and fiscal stabilization, the great powers’ bond markets were growing apart. The rise of private savings banks and post office savings banks may help to explain why bond prices became less responsive to international crises. An investor whose exposure to long-term government bonds was mediated though a savings account might well have overlooked the potential damage a war could do to his net worth, or might well have missed the signs of impending conflict. Yet even to the financially sophisticated, as far as can be judged by the financial press, the First World War came as a surprise. Like an earthquake on a densely populated fault line, its victims had long known that it was a possibility, and how dire its consequences would be; but its timing remained impossible to predict, and therefore beyond the realm of normal risk assessment.”

He warns of the risks that history could repeat itself.

Aside from risks of a long known possibility but whose “timing is impossible to predict” also comes of risks from something beyond what is conventionally known. It is called the Black Swan problem, where swans had been assumed as white until black swans where found in Australia....or risks associated with RANDOMNESS.

To borrow the words of the erudite author Nassim Taleb which he calls as "ludic fallacy" or "the attributes of the uncertainty we face in real life have little connection to the sterilized ones we encounter in exams and games".

The real world is complex, fluid and dynamic. This is in contrast to what is commonly known, or perceived as, or what we know, and could pose as one of the "sterilized" risks probabilities. We maybe overestimating on what we know and underestimating the role of chance. Most of the blowups emanate from unexpected events. Trying to figure or mathematically model all variables is an impossible task; while we try to assimilate risks prospects, the more scenarios we build on, the more questions that comes in mind.

I am not certain if the present ruckus in the subprime markets will diffuse to the general markets. Signs are that the impacts have been minimal; yield spreads in major public and private instruments benchmarks have been little changed, US dollar has even declined, while gold and oil staged strong rebounds. In other words, no relative signs of stress yet.

However if major participants to the subprime mortgage markets find themselves facing a liquidity squeeze enough to provide for a meaningful impact on the Credit and Derivative markets, then there is a likelihood of a contagion to the general financial sphere with systemic repercussions. It would be best to deal with these once the signs of stress or dislocations become more apparent.

Now The Blame Game’s on the Yen

``Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.”-Hyman Minsky, Finance and Profits: The Changing Nature of American Business Cycles, 1980

Last week also tackled on the unwinding of the YEN carry trade as a possible risk to the present bullish momentum of the global markets.

The Economist magazine recently argued that the in spite of the lack of intervention, the present record low levels of the Japanese YEN against the Euro and the real trade weighted value which is now at its lowest level since 1970s according to an index tracked by JP Morgan, see figure 5, the Japanese Yen is “misaligned” and has contributed to the distortion of the global economy, through the exacerbation of the “asset-price bubbles” around the world.

Figure 5: Economist: Living Dangerously?

The preeminent magazine castigated US Secretary of Treasury Hank Paulson for being short-sighted, who had earlier said that the YEN has been market driven and reflects economic fundamentals.

Their gripe is that even with one of the world’s largest current-account surpluses and low levels of inflation, ``the abnormally low rates”, wrote the Economist, ``could be viewed as a form of intervention to hold down the yen.”

Therefore together with the Financial Times editorial both have recommended the use of its excess US dollar ($875 billion) foreign exchange reserves to intervene and shore up the Yen.

I recall Japan spent something like ¥ 35 trillion, about US $320 billion from 2003 until March 2004, representing about 7% of its GDP to depress the Yen’s value on the account of the faltering US Dollar. Unfortunately despite such intervention, the Yen failed to depreciate and instead appreciated, until in 2005 where the US dollar mounted a fierce across-the-board rally. In other words, Japan’s intervention had been essentially a failure and a waste of taxpayer’s money. Today, in the absence of official intervention, the market itself drove the Yen where it is today.

As we have pointed out before, the present concern is that much of the imbalances have been due to the massive leverage employed in the world financial markets, in particular, the Japanese currency as a potential source of leverage, as its currency could have been sold short via currency forward swaps, an off balance sheet transaction which does not appear in official statistics. So where does one get present estimates? According to the Economist, ``through record net “short” positions in the yen futures on the Chicago Mercantile Exchange.”

We don’t know if such estimates are accurate or if any prospective interventions would succeed or simply be another feckless exercise to please the growing chorus for the Japanese to intervene. What we understand is that with such clamor, unlike the Chinese, the Japan may heed the calls for them to take action.

Finally, the Economist relates of a similar incident in the past (emphasis mine), ``In fact, the main trigger for an unwinding of carry trades is likely to be not Japanese interest rates, but an upsurge in currency volatility. That is what happened in 1998, when enormous yen carry trades had built up. After Russia's default in August and the subsequent near collapse of Long-Term Capital Management, hedge funds reduced their leveraged positions and the yen started to rise. Then in October the Japanese government announced a plan to recapitalise its crippled banks, which further bolstered the currency, forcing those who had bet against it to cover their positions. The yen jumped by 13% within three days.’”

Well so much for intervention; with the political equation heating up it won’t be far when George Soros’ theory of self-fulfilling bias may in itself trigger an upsurge in currency volatility.

Be careful on what you wish for.

The Phisix is UP 9%, It’s EASY Money Out There!

``People who look for easy money invariably pay for the privilege of proving conclusively that it cannot be found on this sordid earth.”- Edwin Lefevre, Reminiscences of a Stock Operator

AT the week’s close, the Phisix is up by an astounding 9.6% even as the year has just completed its first chapter.

Yet compared to our region we curiously ranked only 5^th behind the streaking hot Vietnam’s Ho Chi Minh Index 42.94%, which is a mile ahead of the pack, followed by Pakistan’s Karachi 100 15.43%, Bangladesh’s Dhaka Index 13.49% and Malaysia’s KLSE 10.33%. This phenomenon of global capital in search of yields is simply beholding.

Noticeably, except for Singapore’s STI which is likewise up 7.7%, the best performer among our more mature counterparts, it is the “exotic” bourses that have so far provided investors abroad with sterling gains, while other contemporaries have been notably down such as South Korea’s KOSPI, Thailand’s SET and Indonesia’s JKSE, the latter of which outpaced the Phisix last year.

Well of course, our present market performance suggests that we are one of the favorite flavors of today’s cross-border capital flow dynamics. Yet like all other markets, we are subject to the caprices of shifting sentiments, especially considering that the Philippine market has been structurally bolstered by foreign money since the onset of the cyclical reversal in 2003. To ignore this fundamental framework is to engage in wishful thinking.

While it seems that “everyone” today has convincingly turned bullish on the Philippines as a consequence of its inflating asset prices, I remain a short-term skeptic albeit a long-term optimist in the face of a mostly speculative onslaught of global money in the search for diminishing sources of above par returns. In the words of the Bond king, William Gross in his latest outlook (emphasis mine), ``Prices are increasingly being determined by value insensitive flows and speculative leverage as opposed to fundamentals.”

Going back to Philippine stock market internals, I have reverted to my sentiment indicators such as total number of trades and number of daily traded issues as a measure of investor psychology, where present activities possibly denote of emerging indications of “euphoria”.

Figure 1: Rising Number of Trades: Spikes Denotes of Market Tops

As the Phisix ascends, it is natural to expect of accelerating trends in the number of activities in support of an escalating volume turnover. This simply is a demonstration of the bullish outlook represented by “actual” money placements by investors in the bidding up of domestic asset prices. Here money and not words do the talking. In Figure 1, the green line signifies the growing number of trades over the present cycle in support of a rising Phisix.

However, what concern us are the abrupt spikes in the volume, which may be reflective of “manic episodes” by speculators in the market, as reflected by the two pink arrows in the same chart in the past. In the past two weeks, PSE data reflects of several instances of volume surges, a possible manifestation of a probable interim “top”.

When the going gets easy, the proclivities for speculators or the average investors is to amplify on trading activities as profits appear to be “too easy to secure”. In behavioral finance, this could be classified as optimism bias or ``demonstrated systematic tendency for people to be over-optimistic about the outcome of planned actions” [wikepedia.org] or sheer overconfidence or the ``tendency to overestimate one’s own abilities”. In short, sucker’s monies are being lured into a trap of speculative frenzy.

Figure 2: stockcharts.com: Phisix: The Allure and Pain of Sucker’s money?

IN keeping a historical perspective as a possible reprise to present events we can see in Figure 2, the results of the past spikes! As easy money gets enticed into the market on the account of the expectations of a perpetuation of the recent momentum, as in the March 2005 and May 2006 case (two blue horizontal arrows), the following “repricing” sets in the angst of sucker’s money following the sharp declines (downtrend lines). Could we be facing the same pattern anew?

Figure 3: Daily Traded Issues: Intensifying Broad based activities signifies speculative biases

As we have observed in the past, broadbased activities have also been growing, reflecting similar signs of investor’s restiveness to prop up EVEN third tier or highly speculative issues, another manifestation of overconfidence or the speculative bent of the market participants as shown in Figure 3.

The scale of present activities has now surpassed that of the March 2005 and May 2006 peaks, where in the past became temporary inflection points. Could today’s upsurge in broad market activities be another signal that our market has entered into the “manic” stage where the day of reckoning for the sucker’s allure could be nearing?

If I may add the gains of today’s market have been more significant than the gains accrued in March 2005 or May 2006, such that in the context of a possible interim trend reversal, the likelihood is that of a sharper decline than in the recent past. That is if we take into the grounds of market cycle probabilities.

Activities in the financial markets defy real life experiences; where in the real world buyers and sellers would haggle intensely or seek a compromise to attain perceived beneficial values, in the financial marketplace, investors either frenetically bid up or dump securities (“like there is no tomorrow”) especially accentuated during major turning points. An analogy would be like in a tiangge, where one would bargain for items being on sale, whereas in the financial markets, as in today’s conditions, share prices are determined by buyers aggressively meeting up the seller’s price.

The public inveigled by “stories” on many fronts, many if not most of them are highly irrelevant to the prices of the underlying securities, are prompted to take action merely on the account of “social” or “peer” pressures or the crowd effect or herding behavior. A good example would be the mining sector, issues with “claims to mining rights” have been outperforming those with fundamentals, just how relevant are these “claims” to their underlying share valuation is anyone’s guess [claims do not signify the commercial viability of reserves], but apparently not from a fundamental standpoint. In short, it’s all about rampant speculation.

In addition, have one considered lately that activities in the financial markets are premised upon obtaining securities in the hope that another party would take upon a similar position but at a price better than one had acquired? Such concept is nonetheless called the Greater Fool Theory, which investopedia.com defines as ``A theory that it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger fool) who is willing to pay the higher price.”

This phenomenon can be gleaned from market participants with very short-term time horizons as they attempt to chase prices in the hope that a greater fool will be out there to imbue on someone else’s folly. As the legendary and most successful stock market investor Mr. Warren Buffett once warned, “the dumbest reason in the world to buy a stock is simply because it is going up”, for the speculating public today, it is the reverse, the dumbest reason is for one to be left out of fad.

While everyone would have whatever justifications to be bullish in today’s market; namely, “cheap”, “growing earnings/revenues/production...etc” [as if earnings really mattered in pricing securities-am speaking domestically; in 2002 no one wanted to talk about anything about the stockmarket], proposed “backdoor” listings, rumored mergers and acquisitions, proposed expansions, better “economic outlook” due to “reforms” and other pabulums; the Philippine market is factually driven by foreign money and most probably fostered upon the account of a global inflationary [exploding money and credit] environment.

All these are presently being manifested in the world asset markets with the Philippines as part of the beneficiary of the “financial globalization”, this report from Bloomberg’s Oliver Biggadike on the present surging liquidity (emphasis mine), ``Domestic liquidity expanded 21.4 percent in December from a year earlier, following November's 18.5 percent gain, Tetangco told reporters last night. Money supply, which grew 16.1 percent in October, is expanding on record remittances from overseas nationals and investment in the country's stocks and bonds.” [I have long argued that the rise of the Peso has been mostly determined by portfolio flows and regional support at the margins...need I say more?]

As recap, market internals appear to highlight signs of a developing mania which could be indicative of a nearing inflection point, however, manias can last longer or intensify more than one can imagine. In manias, the greater fool theory is the prevalent theme as market participants become more emotionally attached to the present gains of the market as a permanent feature of the market’s landscape. Any “stories”, however irrelevant, are used to justify activities to scoop up share prices regardless of valuations, hoping that a greater fool will be willing to pay for it on higher prices.

Finally, since the Phisix has been driven by foreign money, any catalyst to a possible “culmination” or “climax” could, in most probability, come from external sources as that of the May 2006 incident. Whether the Phisix would suddenly become “expensive” in the foreign fund’s point of view or a global readjustment in the risk premia or an abrupt surge in the downside volatility could trigger a shift in psychology and cause a “repricing of some assets” as warned by Jean-Claude Trichet, president of the European Central Bank. Politics as some may suggest would have little impact on today’s capital flow dynamics unless it threatens the very nature of its functionality, as explained last week.

Be careful out there.

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.