US Markets: Risks of Ponzi and Speculative Finance

``Liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets".-Albert Edwards "Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity", Dresdner Kleinwort Global Strategy Report

One could always argue to say that since the Phisix has been inspired by global markets, particularly the US benchmark Dow Jones Industrials, wouldn’t it be more practical to compare the directional path of the Phisix to its developed market counterparts? Let’s see.

First, speaking of risks, I’d like to first borrow PIMCO’s Paul McCulley quote of the Hyman Minsky, the father of the Financial Instability Hypothesis, where the transitory structure of the credit markets shifts from one marked by stability to another which eventually destabilizes. The Financial Instability Hypothesis was first articulated in 1974 but published in 1991, whose excerpt is quite academic yet I think presents as the real menace to today’s finance-driven economies (emphasis mine)...

``Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

``It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

``In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Evidence shows that “Modern Finance” has been underpinned by such transformations into the above “speculative finance” and “ponzi” spheres, such as the proliferation of “structured finance”, derivatives, and other innovative financial products.

Some hedge funds are even said to have employed by as much as 50 times leverage relative to its capital, where a 2% decline in the securities invested would effectively translate to complete or 100% capital loss! In other words, the ocean of credit creation and intermediation has led to diminished returns, more risk undertaking, narrower spreads and the seeming ambiance of low volatility, where in true dimension reveal nothing more than inflationary manifestations accommodated by the global governments. Such processes are natural offshoots to the order of Paper or Fiat money standards.

I was recently asked of what I thought would be the probable effect of former Fed Chief Alan Greenspan’s pronouncement that the US had ``one-third probability'' of a U.S. recession this year. Further, Mr. Greenspan likewise noted that the current expansion won’t have the same degree of endurance compared to its decade long predecessor, quoting Mr. Greenspan ``Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter' and is likely to be this time”.

While my reply was to essentially heed the signals of the different markets, my humble opinion is that it would be better for the US to undergo such adjustment process for country to be able to cleanse the excesses built into the system.

In exchange for short term turbulence would be gains on a sounder footing over the longer term. Does it not follow in the context of economic cycles that the next phase after recession would be a recovery? So what is so bad with a recession?

Although my main concern has NOT been that of a technical US recession, but of a possible implosion of leverage that could affect the entire global financial and monetary structure and cancel out the present gains in the system.

Figure 2: Casey Research: Exploding Derivatives

Figure 2 from Doug Casey shows of the exponential growth of OTC derivatives, one of the potential epicenters for the markets’ dislocation, quoting Mr. Doug Casey (emphasis mine),

``The collective result is that our financial system has been wired up to $370 trillion dollars of privately negotiated investment contracts. They’re usually written to shift risk from one bank, pension fund, insurance company or brokerage firm to another. And many are linked together in long chains, with each contract providing collateral for the next.

``It’s all very clever, but layering the enormous size– $370 trillion dollars, far more than the net worth of all the financial institutions in the world – on top of all that complexity is downright scary. In simpler times, a home loan going bad would affect only the particular lender. Enough defaults would put the lender out of business. And that would be the end of it. But today a wave of defaults can send a shock through the portfolios of financial institutions around the globe, including hedge funds, banks and pension funds far removed from the troubled borrowers.”

Yet the optimism exuded by the bulls have been premised on the notion of a BERNANKE PUT, where the FED or the Working Group of Financial Markets a.k.a. Plunge Protection Team would intervene and provide for the liquidity of last resorts to the finance driven US economy.

For instance, Jeremy Siegel of Wharton in his interview debunks risks of emanating from hedge funds (emphasis mine), ``Could they precipitate a crisis? Not with the Fed on top of it. The Fed can diffuse any crisis. If everyone gets on one side of the market and things are out of control, the Fed is the ultimate source of liquidity. I think that they can prevent that from spinning out of control. So at this particular point, let people follow those paths that they think are most profitable.”

There are those who claim that the US government would not step in to the rescue of the US economy as evidenced by its non-intervention in the ongoing subprime woes. Past actions have not been substantiated by this claim, namely the S&L crisis, Tequila Crisis, Asian Financial Crisis, Russia Crisis, Y2K jitters, the most recent Dotcom bust or 9-11, where the FED responded with liquidity injections.

These actions by the FED have in fact spawned the overconfidence and increased risk taking appetite as denoted through by Mr. Siegel’s comments that governments are always there to cushion investors from the market’s volatilities. And reading through the present action, the recent ruckus in the markets has NOT BEEN SIGNIFICANT enough to openly prompt for any action from the FED YET (they are still quibbling about inflation!).

Whereas even if FED were to intervene both Mr. Paul McCulley of PIMCO and David Rosenberg of Merrill Lynch suggests that such meddling would be least potent or would not have much significance to mitigate on the effects of the ongoing hemorrhage in the housing industry.

In the astute words of Paul McCulley (emphasis mine), ``It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.”

From Merrill Lynch’s David Rosenberg as quoted by the Daily Reckoning (emphasis mine), ``“What drove the housing-led cycle was not as much the cost of credit, but rather the widespread availability of credit - irrespective of your FICO score [a measure of your ability to repay]...only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

In other words, the bleeding in the housing industry would not be stanched by the prospective FED intervention by the lowering of interest rates, from which the financial markets have mostly priced in their gains from. Both expect the housing woes to diffuse into the greater segment of the economy, which enhances the risks of a greater- than-expected slowdown.

Another example of Ponzi-derived leverage is the YEN Carry arbitrage. While some analysts have debunked the extent of its influence due to lack of concrete evidences from official fund flows, the coincidental effects manifested by the movements of the Japanese Yen and the global markets have been simply so compelling to dismiss.

Figure 3: Stockcharts.com: Overblown Carry Trade?

In figure 3, the initial impact of the Yen’s (superimposed line chart) surge coincided with the tremors in the global equity markets represented by the Dow Jones Industrial Averages (candlestick) and the Dow Jones World Index (lower pane) as shown by the blue arrows. Last week’s steep selloff in the Yen have likewise mirrored the rally in the Global markets (green arrows).

Many argue that macro factors as demographics (aging population seeking higher returns), as well as micro fundamentals as the tentative growth outlook have not been supportive of a sustained rally in the Yen.

Figure 4: John Murphy: The YEN on MAJOR SUPPORT

According to the Economist quoted last February, the Japanese Yen has been undervalued by 28% (!) against the US dollar based on the Big Mac Index and 40% (!) undervalued against the Euro, making it the world’s most inexpensive major currency!

As figure 4 from John Murphy of stockcharts.com shows, the Yen sits on massive multi-year support levels seen in the EURO (left window) and the US dollar (right window). Testing critical support levels of this nature could be expected to incur violent reactions of which we had earlier witnessed. Nonetheless, the YEN on both pairs have been extremely oversold and should naturally begin its ascent.

What significance does this imply to global markets? If the camp of analysts who claim that the YEN trade has not been a major factor in the recent carnage are right, then we could expect the financial markets to simply shrug off any potential rise in the Yen as it bounces of the major support area.

On the other hand, if what we observed would continue to dictate on the market’s interim actions then a rising yen could UPSET any actions initiated by the bulls which would imply for more selling pressures.

Figure 5: Economist: Reintroduction of Risks

The global contagion has reintroduced the concept of risk where it has once been thought to have gone into hibernation as shown by Figure 5 from the Economist.

Figure 6: Northern Trust: Corporate Equities: Supplies go Down, Price Rises

If you think all the tremendous money and credit generated and distributed had been channeled to “productive” investments, Figure 6 from Northern Trust reveals that the recent winning streak in the financial markets have been likewise due to the massive “retirement” in the supply side of equities emanating mostly from the idle surplus capital from corporations and private equity deals.

According to Paul Kariel of Northern Trust (emphasis mine), ``As one can see, a record $548 billion of equities were “retired” in 2006. This is not only a record retirement in dollar terms but also a record relative to nominal GDP. Rather than engaging in a capital spending boom with their recent profit largesse, corporations have been buying back their publicly-traded equity shares with abandon. In addition, the surge in private equity activity has retired shares. So, with the record contraction in the supply (in flow terms) of shares, is it any wonder that the price of shares rose last year?”

Yet Mr. Kasriel further notes that foreign buying has mainly been providing support to these share “retirements” while at the same time HOUSEHOLDs directly or indirectly have used this to finance consumption in place of a slowing mortgage equity withdrawal.

The problem is that as the housing woes deepens, source of funding for US consumers becomes more strained unless they curb their spending patterns and or grow their income faster and or the clip of supply side “retirements” accelerate and or discover other alternative sources for liquidity generation (possibly more debt). This anew poses as another variable which may present itself as more risk to the bullish premises.

The dynamics of share “retirements” or buybacks by corporations coupled with record amounts of insider selling prior to the recent selloffs can be viewed as circumstantial evidences in the light of non-productive investments in support of a privileged few. The growing income inequality gap in the US is nonetheless a manifestation of the continuing “Monetary” inflation policies and the unsound practices of the present Paper based money system.

Finally, whether the recent tumult was due to the Japanese yen, dislocation brought about by unwinding leverage, escalation of mortgage woes, decelerating earnings growth, reversal of expected “liquidity of last resort” or the “Bernanke Put” from the Fed or the lack of continued support from foreigners on the supply side of the equities equation or questions on the sustainability of debt driven consumption or inverted yield curve or the much loathed “R” word-whose probabilities appears increasing by the day, all these points to the horizon where the markets looks increasingly tilted towards heightened volatility going into the interim future.

Risk only amounts you can sleep on; buy on panics and do tighten your stops.

Phisix: Playing Out Our Script

``Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success.'' –Warren Buffett

Finally, the market plays out our long and much awaited script!

While it may be close to impossible to determine such timing with pinpoint precision, market CYCLES eventually PREVAIL.

We had earlier described the local market as “knocking” on history’s door based on the bullish momentum in an attempt to crossover the resistance level. We also observed that budding speculative fervor from within represented risks of EUPHORIA, where similar circumstances in the past alluded to imminent TOPS. [The Phisix fell 7.35% over the week!]

We also discussed of the extreme bullishness as not being confined to the premises of the domestic arena and that the pervasive winning streak in global equities has led to similar sentimental buoyancies here and abroad. We even cited China and Vietnam experience as examples of a brewing “mania”. [China fell 9.2% in a single day!]

If there is any one indispensable lesson from this week’s activities, it is that WORLD dynamics and NOT local events have now proven to be the major determinants of the directional paths of our market, in stark contrast to what has been long promoted by our “experts” and the media. FINANCIAL GLOBALIZATION has been its KEY catalyst, where as described over and over again, as with the shared benefits comes with it the risks of contagion. [World markets from the Americas, EUROPE, Asia and MENA regions have taken a beating!]

Moreover, because of the growing significance of the asset markets in shaping today’s “finance-based” economies, governments have been sensitive to such developments and have attempted to extend CONTROL, which has lead to UNINTENDED consequences. Last week’s “Shanghai Surprise” as some market pundits call it, a crash which resonated around the world, and previously in Thailand serves as concrete examples.

Lastly, as also described in the past, RANDOMNESS, or aptly known as “Black Swan” or HIGH SIGMA standard deviation or “FAT Tail” [low probability but high impact-events], applies to the market beyond the confines of any sophisticated high tech mathematical or chart models. Here, past actions have failed to determine future activities. [There is much surprise to the markets than we are wont to believe.]

The Blame is on China’s “Shanghai Surprise”, But....

``Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” -- George Soros

MEDIA has been plastered with reports that China’s “Shanghai Surprise” was the culprit to last week’s highly volatile activities worldwide. Nonetheless, the public including many analysts openly embraced such supposition.

As a disciple of the market, we try to keep in mind the premises of Frederic Bastiat’s theory; “That which is Seen and that which is UNSEEN” or the parable of the Broken Window. The theory essentially deals with OPPORTUNITY COSTS.

What is SEEN today is that CHINA’s crash virtually CAUSED the maelstrom in the global financial markets last week.

While it may be true that the initial tremors in the global markets have been staged at China, the predicated causality is very much in doubt. In other words, I do not share what I perceive as a logical fallacy POST HOC ERGO PROPTER HOC “after this, therefore because of this” as espoused by the mainstream.

Figure 1: Bloomberg: Shanghai Composite: Not The First Time!

The market usually responds to a shock violently. But, in the case of China, this is clearly not the first time! Morever, the last shock happened in less than a month’s period!

In Figure 1, courtesy of Bloomberg, China’s bourses have come under siege from its authorities trying to rein in the “bubble-like” phenomenon in its equities market.

In late January of this year, according to a Forbes report, ``Cheng Siwei, vice-chairman of the National People's Congress, warned investors not to engage in speculative activity in the stockmarket because of the risk of a bubble developing and bursting, causing heavy losses, the Financial News reported.”

The warning allegedly contributed to a harrowing one day 6.5% decline as exhibited by the red arrow on both the Shanghai and Shenzhen bourses. Yet, the world has basically ignored such happenstance.

Could this suggest that since the world discounted the earlier drop, that the bigger magnitude (9.2% on Tuesday) had more of an impact to trigger a domino effect? I doubt so.

Second, one must be reminded that China’s financial markets are severely constrained by choking government regulations, where both domestic and foreign investors have limited options. Edmund Harriss of Guinness Atkinson describes best the conditions from Ground Zero (emphasis mine),

``The Chinese stock markets are in reality very thin in terms of market participants. In spite of the huge numbers of brokerage accounts a small number of funds, companies and high net worth individuals dominate the market. And they invest on the basis of Technical Analysis (i.e. price patterns) and News Flow, not on Valuations.

``The markets are also ring fenced by China’s closed capital account that means there is no general freedom to move money in and out of the Yuan or in and out of the country. Foreign investors are allowed into the domestic market but on highly restrictive terms and local investors are not allowed to go outside except on highly restrictive terms.

``So local investors don’t really have a choice. Or they do, but not a very attractive one. They can invest their money in bank deposits which will pay 2.52% for a one year deposit; or they can buy a 2.5% guaranteed return product from an insurance company; or they might invest in government bonds that currently yield under 2.65% for the ten-year, if they can get them. No wonder that when they see a hot thing they are on to it.

``But this means that Chinese stock markets do not adequately reflect local economic conditions, in our opinion and therefore should not be used to predict global ones. High volatility and high valuations are part and parcel of inadequately functioning stock markets.”

In an interview at Bloomberg, the illustrious veteran Mark Mobius of the Templeton fund basically shares the same view that China’s market is overvalued whose present activities shows disconnect from economic realities. Mr. Mobius thinks that China’s bourses will continue to suffer from selling pressures over the interim.

Figure 2: LA Times: Tail Wags the Dog?

Third, it is important to note that for a domino effect to take place means having a significant correlation on certain variable/s. In this case the connecting factor should be accessibility of foreign money to China’s equity assets. Yet, Mr. Harriss mentions that investments from foreign investors are as limited. LA Times estimates that these accounts for less than 3% of its market value.

Theglobeandmail.com quotes Arthur Kroeber, director of Dragonomics Research in Beijing in estimating the size and depth of the Chinese market, ``Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares...Only about $400-billion worth of shares can be legally traded now, and of this amount, only about $160-billion are held by retail or institutional investors.”

Globeandmail.com continues (emphasis mine), ``This means that 60 per cent of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status.”

This brings us to question on the foundations of the “China-driven contagion”; how SIGNIFICANT can it be for China’s $400 billion worth of tradeable shares or even less (remember 60% held by the ruling class) or $1.3 trillion of market cap [representing a measly 2.2% of the aggregate global market cap, see figure 2] to severely AFFECT a northward $70 trillion in world market cap?

The corollary is to suggest that Philippine market’s crash (market cap about US $80+ billion) CAUSED the carnage of the China’s bourse. How awkward can such reasoning be!

While I am seeing a sea of blood across the world’s bourses following Tuesday’s selloff, it is noteworthy to observe that Vietnam has been entirely unscathed and continues to race upwards with an amazing 5.95% advance over the week! In other words, because Vietnam’s stock market has a similar construct to that of China, i.e. restricted foreign investments, it has been less susceptible to global capital flow dynamics and relies on domestic developments as its main driver.

Remember in this age of digitalization, we are talking about global money flows at the click of a mouse. It is worth repeating that while China’s market cap is ONLY US$1.3 trillion, where about $200 billion is essentially exposed to the public or could be owned by foreign money! In contrast, our domestic market has been dictated by foreign money accounting for more than HALF of its turnover since the cycle reversed in 2003. This subjects us to the shared risks and benefits of a globalized market.

In addition, China’s loss of ten percent (10%) in nominal terms is equivalent to only US$ 130 billion, in contrast to the aggregate US market cap, which at an estimated US $27 trillion (NYSE, AMEX, Nasdaq et. al.), lost US $810 billion or 3% (rounded off) or about two-thirds of China’s market cap! So which do you think is suppose to have a larger impact on global markets?

Fourth, while it is said that the new rules imposed by the Chinese authorities aimed at curbing rampant speculation as being responsible for the carnage, this seemed to have a belated effect. According to Barry Ritholtz (emphasis mine),

``China's Shanghai and Shenzhen stock exchanges issued on Sunday the new rules of regulating their member securities companies in a bid to ward off risks in stock trading. The rules, which will come into effect on May 1, set limits to the varieties, methods and scales of stock trading that dealers are allowed to conduct, preventing them from engaging in high-risk business beyond their capacity.

``Note that these details were released on Sunday, and on Monday Chinese markets set new all-time record highs! Indeed, despite recent official discussions of new capital gains taxes, increased regulation and the government's desire to reduce speculation in China, their indices had advanced 13% in the prior six sessions -- all setting records.”

Where markets are supposed to react to new information supplied, a seemingly belated effect implies detached reality. In other words, China’s market fell NOT on the NEW rules but on some other underlying UNSEEN factors.

With the snowballing signs of mania, where people have now been borrowing against their homes to gamble or “dubo ji,” or the slot machine, as the New Times calls it, on the stock markets, the government perhaps or probably made use of their sizeable ownership of listed companies to douse on the brewing irrational exuberance by dumping their shares.

Why? Perhaps for political survival, Morgan Stanley’s Stephen Roach thinks that the present leadership views market intervention as part of measures to stabilize the situation, he writes (emphasis mine), ``In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system.”

In short, for investors, it is hard to earn on markets where the APPARATCHIKS DECIDES TO PLAY GOD!

Anyway, I don’t think much of the market actions in China would diffuse into its economy or translate to a consumer crisis, considering that only about 8% of the household assets as estimated by the Mr. Harrisss of Guinness Atkinson are exposed to equities (76% in bank deposits, 9% bonds, 7% insurance). You’d have to look elsewhere for a compelling case that could trigger a “domino effect”.

For all its worth, I believe that the global markets have simply used the “Shanghai Surprise” incident as merely a scapegoat for something much deeper, yet the public has warmly accepted such logical fallacies as “truths”.

Forget China, Circumstantial Evidences Reveal the Unwinding of Carry Trades

In the US, there have been numerous “rationalizations” floated as the reasons for the current “shock” or the reappearance of volatility.

Some attributed it to the comments of former Fed chief Alan Greenspan who uttered the “R” word on Monday in a business conference in Hong Kong in front of group of private investors. Because Mr. Greenspan possibly felt that he may have influenced the recent activities, he quickly clarified his position on Thursday saying that, as quoted in Bloomberg, ``By the end of the year, there is a possibility, but not a probability, of the U.S. moving into a recession.”

Like our previous observations, Greenspan noted of the legions of risks that have been dismissed by the cheerful consensus, where according to the same report by Bloomberg, ``Current low yield premiums aren't sustainable, profit margins are peaking and the U.S. growth cycle is in a mature phase, Greenspan said today. The former Fed chairman said previous experience suggests a flattening of profit margins should produce a recession.”

There are also reports that technical glitches in the Dow Jones Indices helped exacerbate Tuesday’s biggest decline since 2003.

Of course, I don’t buy these myths, analyst Barry Ritholtz aptly wrote to debunk every bit such “rationalizations” in his article the “10 myths in Tuesday’s Correction” whose conclusions I would share (emphasize mine),

``Since the summer, the rampaging bulls have had their way with just about every market on earth. Volatility had been subdued and risks ignored.

``That era is likely over now. Indeed, the general commentary ("buy the dip, hold for the long term") may be ignoring a developing shift in psychology. It reeks of complacency.

``In a note to clients after the plunge, we said to expect three things:

1) Increased volatility;

2) attempt(s) to return to prior market highs;

3) deeply oversold conditions that will eventually create great entry points.”

Now moving to the UNSEEN, here we have one phenomenon that appears to have taken place coincidentally, as the market soldoff. It is something that we have prominently discussed in the past and the issue is no less than the CARRY Trade.

Figure 3: Stockcharts.com: Unwinding Carry Trades? The Funding Currencies

Two funding currencies or currencies arbitraged to finance investments in other asset markets, the Swiss Franc (lower pane) and the Japanese Yen (superimposed) rallied furiously as global markets were sold down the drain, the Swiss Franc was up 1.36% (w-o-w) while the Japanese Yen soared 3.73%. Since the world markets have essentially been highly correlated with the US benchmarks, I placed the Dow Jones Industrial Averages as representative (candlestick).

Figure 3, tells us that the rally has been simultaneous in terms of timeframe [blue arrows] and correlated in terms of magnitude [degree of rallies of the Yen inverse to the degree of decline in invested assets.].

Figure 4: Stockcharts.com: Unwinding Carry Trades? The Invested Assets/Currencies

In Figure 4, the invested asset/currencies which benefited mostly from the Carry Trade, the South African Rand (upper window) and the Australian Dollar (lower window), as well as the emerging Market MSCI benchmark (center chart) have likewise shown a replication of activities albeit on an inverse scale relative to timeframe and magnitude.

Put differently, while there have been incessant blathers about what’s driving today’s markets, it looks as if the dynamics of the unwinding of the Carry trade similar to May of 2006 has played a big PART among the variables involved, as the circumstantial evidence above suggests. The US and the world markets appear to be at the short end of the unraveling of the Carry Trade.

And this is not without precedent, Mike Larson of Money and Markets, ``It’s happened before, most notably during hedge fund Long Term Capital Management’s (LTCM) meltdown in 1998. The yen surged 9% in a matter of weeks that summer, then skyrocketed another 12% in just 72 hours!” Déjà vu?

However, I wouldn’t venture into justifying these as the CAUSAL factors lest be accused of another logical fallacy Cum Hoc, Ergo Propter Hoc” [With this, therefore because of this]. We will have to see if the trend continues to play out in the following weeks.

A Bird At Hand is Worth Two in The Bush

The recent reemergence of volatility has interposed the question on whether this has simply been a respite or a much needed correction for a continued upside move or a pivotal turnaround or reversal. Since the Philippine markets have been largely influenced by the actions in US equities we then would take a clue on the latter’s prospects.

Mr. Adam Lass, Senior Market Analyst, WaveStrength Options Weekly chronicles how the Dow Jones behaved when it dropped 5% in the past.

Quoting Mr. Lass (emphasis mine), ``The largest episodic loss was March-October 2002’s 32.57%, while the smallest was August-October 2005’s 5.25%. The average for all 15 retracements was 15.01%, four were less than 10%, eight were between 10% and 20%, and three were more than 20%.

``So what does this tell us about where the market could be headed next? During the current drop, the Dow has fallen as much as 5.75%. Of the past 15 similar drops, only one time during the August-October 2005 drop, did losses stop at this level.

``Time-wise, the average duration of a fall is 2.53 months and the average latency period from the end of one drop to the beginning of the next is 5.4 months.

In other words, the probability looks tilted towards a continuity of heightened volatility. Only 6.67% (1/15) of the time did the correction stop at this level, while the average may see a decline of about 15%. For as long as the Phisix gets its vitality from the actions of the US markets, we could probably encounter a similar degree of market activity where the risk reward trade off seems to favor more of the downside.

Whether today’s decline is fundamentally supported or not, developments have yet to clear itself, meaning greater uncertainties tend to produce higher volatilities.

Where the path of least resistance is obviously on a downside move, except for US treasuries, a large swathe of the asset classes remain under pressure, surprisingly including the US dollar (I mean the US dollar index) and gold. I think, as the Phisix and the other Philippine asset classes remains under pressure, the Peso will reflect similar circumstances [My hunch is that the Peso could rally to around 51 before reassuming its uptrend].

It pays to probably be prudent by lightening up or underweighting one’s portfolio. And take OVERSOLD opportunities in the market to either load up and trade over the short-term or accumulate for the longer period, as we remain bullish over the longer trend cycle BARRING a global depression. To quote the oracle in Aesop ``a bird at hand is worth two in the bush”.

Ignoring Black Swans and Market Cycles

``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability." Nassim Nicholas Taleb

I find it odd when local authorities come to defend the market as if they can actually move or change the direction of the markets or reverse a cycle on their sheer pronouncements.

In response to the market’s carnage, I read a government official saying that the selloff was an “overreaction” and “did not reflect the fundamentals”. How I wish they were singing the same tune in 2002.

In another article, a press conference of key market participants were quick to point out that low interest rates, cheap valuations, the country’s improving fiscal position, sanguine economic and corporate prospects plus slew of IPOs and buzzing corporate activities as potential catalyst to the market’s rebound.

Yet unknown to many, most of the grounds cited have been based on recent actions. Yes, present conditions have been extrapolated to project future outcomes, in the face of a “shock”. By shock I mean the unexpected contagion effect experienced our financial markets last week.

Take for example low interest rates and inflation; the deluge of money flows from remittances and portfolio and direct investments have been mainly responsible for these.

Portfolio investment at the margins as I have interminably argued has driven the Peso to record highs.

And the global phenomenon of money chasing for expanded yields have caused Philippine bonds to rally vigorously whose spreads with US treasuries have been at record lows. These essentially constitute the key factors that have brought down interest rates, aside from the appreciating Peso which has contributed to the decline of consumer “inflation” rates.

In addition, in the corporate field, 14 companies are lined up for this year’s scheduled IPOs while corporate activities have been abuzz, mostly because of the impressive performance of the Phisix as well as the market’s warm reception to the most recent IPOs.

Now think of what happens if portfolio flows reverse? The Peso will decline which should lead to higher interest rates and rising pressure on the consumer “price” inflation front.

If the Phisix continues to drop then many of these corporate activities could be deferred or shelved until a better time, and so as with the other corporate activities.

In other words, the scenario painted our experts will radically change. Yet, it is a public spectacle to see them use past performance in order to defend present conditions in the face of an unexpected or random events. They appear like political demagogues campaigning in today’s election season.

You have to understand that market cycles are simply an outcome of psychological transformations. First there is the “shock” or disbelief phase, then the denial phase and finally the capitulation phase.

In 2002, no one wanted to touch the market simply because it had been agonizingly in decline for several years. It marked the capitulation for the bulls which signified the start of the cyclical reversal.

In 2003, the market began its upside cycle as foreign money drove the index higher. Political jitters, which in the past comprised as a major hurdle, were simply ignored by foreign capital which continued to pile on our asset markets. Yet, many local investors remain in denial over this period.

And as the trend gets more entrenched and under the backdrop of the steep advances of 2006-7, many local investors succumbed to the rising tide, and commenced upon entering the market, in view that the prevailing trend will last.

Today, the chorus is that the Philippines is on a mend, viewed under the premises of the rising asset class, and as such declare the continuity of the present micro trends. Slowly but surely we seem to be entering the next phase of the cycle; bearish capitulation.

Most, however, continue to ignore the fact that macro drivers have been responsible for these advances, and when the macro factors turns against us, you’d likely see an interim reversal of the present activities. Last week appears to be our proof; the market and the Peso tumbled significantly.

Yet the macro developments could also be a function of the transitional cyclical phases of the world markets, where big price fluctuations are a natural phenomenon.

In a study by MIT economists, evidences has been produced that such outcomes have been periodical. According to analyst Mark Hulbert (emphasis mine), ``Their study, published several years ago in the prestigious scientific journal Nature, reports that large daily fluctuations in the stock market occur, on average, at very predictable frequencies. Instead of seeing these fluctuations as abnormal, the academics' theory suggests we see them as inherent features of the stock market's volatility.

``The study's authors derive a complex model that predicts how often declines of Tuesday's magnitude -- 3.3% in the Dow industrials -- will occur. Over many years, according to that theory, they should occur an average of every five to six months.”

Yes, the recent market action appears to be INITIALLY a cyclical behavior in response to an overheated market worldwide, since trends don’t move in linear fashion.

As I wrote a favorite client, ``But who would accept such explanation? Would you? There has always to be some reason/s. And that is where media loves to feed on...simplistic thinking; which will be what most of the investing public would be willing to digest, including your favorite sources of information.”

In a similar tone I found this very noteworthy quote from the Mr. Black Swan himself Mr. Nassim Nicholas Taleb from his soon-to-be-published book The Black Swan: The Impact of the Highly Improbable, ``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability."

Until we see further evidences that support the recent declines as fundamental [macro] based then it would best to treat today’s retreat as simply “inherent features of stock market’s volatility” or cyclical phases of markets.

Lastly, avoid from accepting pabulums premised on past performances, because as the markets have shown last week, Black Swans exists!

Epicenter China? The Return of Volatility on an Unwinding Yen Carry?

China stocks tumbled the most in 10 years! Global indices seem to be feeling tremor while at the same time the Yen rallies across the board! Are we seeing the return of volatility via an unwinding YEN CARRY or is this merely a head fake? We'll see.

Gold Watch: Gold Breaks Out in Yen!

We have been bullish on gold premised mostly on the flawed structural conditions of the global monetary system. Where no country wants to have a strong currency, gold flourishes as neutral currency against these circumstances.

As such, gold’s rise has not been solely against the US dollar but against all major currencies. Gold's performance against key currencies during the past two years in the table above borrowed from one of my favorite analyst John Maudlin.

The latest rebound of gold in the US dollar is also a worldwide phenomenon, and thanks to Fullermoney.com, we may have a clue on where gold maybe headed for. According to Fullermoney.com, ``This is the first breakout against a reserve currency following the May-June 2006 correction.” Yes, Gold prices breaks out in Yen prices! Will Gold in US dollar follow suit?

The Phisix Knocks On History

``Global finance is a dark hole. There are more investors in more countries moving more money into more securities in more other countries than ever before. Herd behavior sometimes overwhelms the natural tendency of markets to self-correct, often harmlessly to everyone but overeager investors. Large losses in one market could trigger selling in others. Confidence and spending could weaken. What's unnerving about the global money bazaar is not what we know; it's what we don't know.”-Robert J. Samuelson, Storm Cloud at the Global Bazaar?

So what else can I say? As the Phisix continues to hug the limelight, I have been watching in awe as it energetically set another milestone; a fresh TEN year high!

Based on present conditions, the momentum going forward appears to be insuppressible as the torrent of foreign money inflows have now been AUGMENTED by considerable money flows from Philippine residents.

We are just a few points shy from an important breakthrough; the ultimate barrier erected in February 3, 1997 at 3,447.6 is merely 58.23 points distant from Friday’s close! Beyond this level represents uncharted territory. And this dam could be broken anytime soon. Even possibly by the time you’d be reading this. While I am delighted to witness the Phisix approach my long term goal of 10,000, the prevailing rhapsodical sentiment represents much of a cause of concern in my view.

The Phisix surged 1.67% over the week, and is up an amazing 13.64% from the start of the year. Market internals continue to manifest record breaking upon record breaking developments.

Figure 1: Local Investor Peso Volume Turnover: Surging Momentum

This week has a different theme though. Where in the past local investors mainly played the supporting role to overseas money, this week they apparently were in control. And as the market continues its upward trek, money from resident investors has gradually been increasing as shown in Figure 1, with the recent volume at its strongest level since the inception of the rally in 2003. For this week, domestic investors had a commanding majority (55.77%) of the aggregate transactions!

You see, when the locals are bullish they tend to fiddle with speculative “illiquid” or highly volatile issues. As testament to the speculative proclivity of the local market participants advancing issues hit another record high (421 over the week)!

And because local investors have been generally ecstatic, trading activities are expected to blossom as they frequently take on short-term positions. Again as evidence to this, total daily trades eked another week of record transactions; the average-an astounding 13,878!

Gadzooks, we are today witnessing another spike or more indications of growing overconfidence! The market is indeed getting quite euphoric.

While this week’s foreign inflows had been the weakest since the start of the year, a tepid Php 959.393 million, the breadth of foreign money flows or issues bought up at the boards have been at the highest level since the cyclical turnaround in 2003! In short, foreign money has also joined the locals in the speculative frenzy.

The penetration level of local investors has been extremely low, despite the recent run-up. According to the estimates of the PSE president last year, as we mentioned previously, only about 1% of our population have investments in the domestic equity market.

Present events indicate that this has been evolving. Where the hunt for higher returns have been a key factor in determining investments worldwide, in the light of further advances of the Phisix and the other Philippine asset classes, we are now witnessing a similar spillover effect to the local domain.

Where the once “risk-averse” public have gradually come to psychologically and socially accept that stockmarket investing as a genuine and legitimate investment channel (instead of gambling arena), this implies a strong support for the Phisix (and the economy) over the long term. I would like to emphasize LONG TERM!

The back of the napkin calculation tells us that if the penetration level of local retail investors would treble or reach 3% of the population or 2.55 million, where each participant would transact P 1m worth a year (P 100k traded 10 times) or in over 240 days (20 trading days/mo. x 12 months), daily volume would translate to about P 10.625 billion a day! Considering the present share of foreign investors of about half of today’s volume, our aggregate daily peso volume should be at around P 20 billion! And this does not yet include local institutional investors. You can just guess estimate the level the Phisix would be in at P 20 billion a day-around 8,000!

From the start of the year, our daily volume averaged about Php 4.462 billion where local investors constituted 45.27% of the accrued transactions or P 2.02 billion. I think this roughly falls in line with the estimated penetration level of local retail investors as quoted by the PSE president.

In other words, while nominal volume has grown, the penetration level has NOT YET grown enough to surpass the levels cited by the PSE president. Over the long run this should serve as ANOTHER BULLISH case for the PHISIX, as we have said before.

HOWEVER, over the SHORT-TERM [pardon my insistence with timeframe references, which in my view signifies a crucial factor in determining absolute returns] with the severe lack of understanding, today’s market participants have been mostly drawn by the prospects of EASY MONEY and by SOCIAL PRESSURE rather than risk-reward/cost-benefit factors.

As an example, some market participants insist of being “cerebral” in their approach towards the market when their influence centers affecting their investment decision making process spring from the analysis emanating from information from either mainstream news/ analysts [momentum or fad based] or stock forums. If successful investing in markets means being “ahead of the curve”, how does one gain from the knowledge or information the public already knows? What distinguishes “noise” from “true” drivers?

There have even been the “personality occults” variable. Because of the relative successes of pushing up of several issues based on the JOCKEYING by some key market personalities, these have been interpreted by some punters as having the magic of “King Midas’ golden touch”, where the future direction of the share prices of some issues on the market is wholly dependent on the “blessings or not” of the market’s version of “King Midas”. In short, stock market “jockeys” and not business viability to some are deemed as critical factors in determining their investment returns! Incredible.

Yet, the gullible public has generally ignored the important truisms of a “rising tide lifts all boats” scenario, or as the legendary trader Jesse Livermore discerningly advised, “In a bullmarket all stocks rise in general”. In its eagerness to speculate [NOT invest] the investing public would consume every story Hook, Line and Sinker on even dubious themes as grounds for their bets.

One must be reminded that while management is indeed essential in determining the success of any business, it is also the long term viability of the business model that matters and not some “castle in the air” models, where short term gains or price-driven momentum advances have been the apparent priority.

Stray no further and recall the Technology bust or the Dot Com Bubble in 2000, where share prices of questionable, capital consuming, non-profitable business paradigms were bidded up to stratospheric levels only to end up nowhere resulting to huge losses by gullible investors (again, people get what they deserve).

In the domestic instance, the 1999 BW Resources Fiasco should refresh our memories. From about 60 cents, the company Greater Resources was transformed to BW Resources which raced to about 107 per share, (premised on a chimera or a fantasy business model-it even topped the market cap of San Miguel, the largest market cap at its peak then!) which was “jockeyed” by known market players allegedly with the support of the political leadership.

At the end of the day, the bubble imploded and its shares prices were brought back to planet earth (from 60 cents to 107 pesos back to 60 cents). Some of the jockeys and the principal of company themselves got nastily burned while many gullible investors, who bought into the fad mostly at the top, today still holds on the issue with enormous losses in the HOPE of its revival (of course, in a reconstituted real estate company).

The important lesson here: People have very short memories. For failing to learn from the mistakes of the past, we would most likely see a repeat of a similar fate...someday. Again in the valued words of Jesse Livermore, ``The stock market never really changes that much. What happened before will happen again and again and again."

Liquidity Driven Global Equity Mania

``The closer you are to the truth and the facts, the more of an edge you have. The further you are, the more risk and higher probability of a telephone game of distorted information and stacked assumptions—each precariously dependent on all the priors.” -Josh Wolfe Nanotech

Well, much of the present euphoria has actually been the same phenomenon worldwide, as global equity assets persist to outperform.

Analyst Gary Dorsch, recently observed that bubbles have been brewing in Shanghai Tokyo and London, in a Kitco article he wrote (emphasis mine),

``But what disturbs Chinese government officials are signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised a record 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. January turnover was five times early 2006 levels. Beijing is now ordering banks to prevent retail borrowing for stock investments....

``The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. The high P/E ratio is supported by expectations of 25% earnings growth for 2006 and 2007, from the possible new tax policy and new accounting standards starting from 2007. However, if 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin.”

Well it’s not just in China, in Vietnam, the rush into equities have spawned a nationwide mania, writes the Financial Times (emphasis mine),

``After watching the formal stock market's main index soar by 249 per cent over the last 13 months, Vietnam's emerging middle class is in the throws of stock market mania and students, civil servants and state enterprise managers with cash to spare are all rushing to buy shares and dreaming of windfall profits....

``Until recently, Vietnamese tended to put what savings they had into more traditional assets such as gold or real estate. But in the past year the number of trading accounts in the Vietnamese stock market has almost quadrupled from 32,000 to about 120,000.

``Brokerages are mushrooming, with 56 now licensed, up from 16 early last year. All kinds of companies are trying to get a bite of what they see as a lucrative business with one state garment maker, Vinatex, recently declaring it would open a stock-broking arm.

Figure 2: Bloomberg: Ho Chi Minh Index

Speculation knows no boundaries. Figure 2 shows of how success relatively attracts more money, the Vietnam Ho Chi Minh Index up 332% in about two years have been enticing novices and punters to take on “dreams” of a windfall.

Once again to quote the Financial Times, ``“It's a frenzy," says Jonathan Pincus, the UN's chief economist in Hanoi. "All the chatter in Hanoi is about people investing in the market. I don't know if anyone knows what these companies are worth, but they are buying the paper." Well one should know of what comes after manias.

At least here in the Philippines, there has been to a lesser degree similar evidences that would YET suggest of a manic intensity with a similar degree, although we are definitely headed into that direction. As I have been saying repeatedly, Manias can last longer and intensify more than one could ever imagine.

Well of course global liquidity is the main reason for all these.

For instance, we mentioned that marketplace liquidity has been growing even locally. Recently, a publicly listed broker CITISECONLINE <COL> announced that it would begin offering margin facilities to its clientele base backed by a P 200 million bank loan.

Anyway, what I am trying to say is that rising collateral values, increasing pressure from clients, attempts to gain market share and the prospects of more commissions would eventually lead brokers to offer margin facilities to their clients as the upward trend of the Phisix gets more entrenched.

Such facility will add to more liquidity in the marketplace as levered money gets recycled back to the markets in search of better returns. With levered money, volatility of asset prices increases and so as with the risks associated with it.

This, in effect, is what we’ve been seeing in the world marketplace.

Figure 3: The Grandich Letter: US Margin Debts at 2000 levels

In the US markets, margin debts have buttressed the present lofty levels of its equity markets, another potential pin that may cause a serious dislocation. Peter Grandich of the Grandich Letter remarked, ``When stock market players get giddy, they tend to feel it’s a one-way street up and getting highly leveraged is just a way to make more money. They attempt this by borrowing heavily against their existing holdings in order to get more equity exposure. You’ll notice we’re now back to levels last seen in 2000. To those who say the stock market peaked then – good eye.”

Since the US markets have generally been highly correlated with our local market, as well as the rest of the other emerging markets, any disorderly unwinding triggered by these highly levered positions could pose as a significant threat to the present momentum.

Homogenous or Divergent Emerging Markets?

``Venezuela, Nigeria, Iraq, Iran!” Everyone is supposed to be terrified and pay up for oil. But, the horror story is not raising risk premiums on risky assets such as emerging market bonds. Nobody seems bothered by the inconsistency.” Andy Xie

Given that emerging markets which is said to have an .85 correlation with developed markets, according to a report from Bloomberg, a correlation of 1 indicates lockstep movement, the activities of the developed markets particularly that of the US has served as a very significant gauge in assessing the risk-return dynamics and determining portfolio allocations.

Would you believe that due to the tsunami of worldwide liquidity which has practically distorted the pricing of different asset classes, emerging market debts have now been priced MORE than the US corporate debts?

According to a report from the Tom Stevenson of the Telegraph (emphasis mine), ``Globe-trotting investors have become so immune to risk that they are happy to accept lower yields on emerging country sovereign debt than on equivalently-rated US corporate bonds, one of the world's largest fixed-income investors said yesterday.”

In what was traditionally considered as riskier investments, investors typically asked for higher yields to compensate for the risks undertaken, as measured relative to “safe” US Treasury bills, where the difference or the spread represented as the premium. As the perception of risks grows or increases, so does the spread or the premium. That was then.

Today comes in a different context; the reasons investors have priced emerging market debts higher could be due to higher growth prospects, improving fiscal conditions and lesser supply relative to the demand of the issued sovereign debt instruments, according to Mr. Stevenson.

Generally this implies that global investors appear to be immune to the political risk spectrum which could translate to financial risks. In addition, this underscores the one track determination in the quest for higher returns. The desperate search for yields has essentially blinded investors into mispricing or discounting such risks. How could one underestimate the political risks considering the emerging tide of leftist leaders being elected in Latin America or of growing geopolitical tensions in the Middle East or of the recent attempts to impose capital control in Thailand?

And largely because of the hunt for yields and the attempts by fund managers to diversify their portfolios to assets which are lesser correlated to developed markets, the S&P came up with a new investing index, as an offshoot to the emerging market class, the S&P/IFCG Frontier Markets Composite Index, which accounts for 22 emerging markets that are too thinly traded or too small, according to a report from Bloomberg. Naturally such exotic themes as we previously discussed continues to outperform most indices considering their high risks nature.

Now comes the highly respected independent research BCA Research, whose recent outlook tells of the surfacing of a lesser degree of homogeneity or divergence among the emerging market class.

Figure 4: BCA Research: Emerging Markets are No longer Homogenous

According to BCA Research, ``The correlation among emerging equity markets and equity sectors has fallen dramatically in recent weeks. This has largely been driven by fundamental factors such as varying valuations in different segments of the equity universe, as well as diverging country trends in inflation, interest rates and cyclical growth profiles. We expect these divergences to persist heading forward.”

Could the present outperformance of the Phisix translate to internal strength of the Philippine asset classes in the eyes of foreign investors? I doubt so, but we will see.