Philippine Stock Exchange: Supported by Global M & A, Secular Trends and Capital Market Developments

``If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue -- relatively, at least -- companies that are out of favor because of unsatisfactory developments of a temporary nature." - Ben Graham (1984-1976), mentor of Warren Buffett

In our January 8 to January 12 edition, [see Unifying Global Stock Markets; Asia Looks Next!] we wrote how global exchanges had been undergoing consolidation trends, and that the deepening financial integration appears to bolster these developments.

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

Recently the London Stock Exchange (LSE) has been the object of interest for acquisition where the Qatar Investment Authority (QIA) acquired 20% of the company while United Arab Emirates’s Borse Dubai in a complex deal with the Nasdaq took over the latter’s stake at LSE to hold an accrued 28% in Europe’s oldest stock exchange in return for Nasdaq’s takeover of the Norway’s Nordic OMX, where the Borse Dubai will also own a significant 19.99% stake.

In Asia, Tokyo Stock Exchange (TSE) in an effort to increase alliances and expand operations recently acquired 5% of the listed Singapore Stock Exchange.

There have also been rumors floating that the Chicago Mercantile Exchange (CME) is interested to acquire substantial positions in the Singapore Bourse Operator, as well as other exchanges around the world.

In short, our thesis that the consolidation trends in global stock exchanges will probably deepen has shown more signs of being validated.

What has this got to do with PSE?

We rarely deal with particular issues but since the PSE is the country’s sole service platform facility for the trading of Philippine equities, or a monopoly at that, we view the PSE as the EMBODIMENT of the Phisix. In short, what happens to the Philippine Stock Exchange will influence the trading activities in the Phisix.

Over the past week, the demutualized Philippine Stock Exchange (PSE) surged 22% to close at 1,005 and is up 258% from the start of the year. It also recorded hefty foreign buying.

While it is speculation on our part that the foreign activities today in the PSE could be part of these global consolidation process, we believe that either this is starting to happen or will become an inevitable part of the financial markets evolution.

Of course, the PSE’s rise could also signify the attendant breakout of the Phisix which recently carve out its NEW highs since the PSE came into existence.

In other words, if you share my view that the Phisix’s long term or secular tend will reach at least 10,000 in the next 5 years, then the PSE is a no brainer, since a rising Phisix will command higher volumes, more fees, more IPOs and an expanded business frontier.

Further with present thrust of our country to continually develop our capital markets, major future projects are lined up for the PSE, such as the proposed incorporation of derivatives trading, the present inclusion of several Phisix member companies in the ASEAN ETF traded in Singapore’s Exchange which could pave way for the future trading of Exchange Traded Funds, the recent introduction of the Securities Borrowing and Lending (SBL), and the prospective cross border listing or listing of shares of a foreign publicly listed company in the Philippine exchange.

Where such capital market enhancements provide investors alternative options and instruments to spread and hedge risks and as well as aim for expanded returns, one can expect the sophistication of asset management to attract significantly more investors in our underappreciated capital markets.

Figure 6 and 7 shows of how PSE’s contemporaries have performed over the past 5 years…

Figure 6: Yahoo.com: Bursa Malaysia and HK Stock Exchange

Having been a dull “lack of story” stock, we never expected an outperformance from the exchange issues, which implies PSE is not a stock for everyone, until now…

But so far exchanges have provided investors with magnificent returns as shown by our neighbors the Bursa Malaysia (left) has jumped 2.5 times since its listing in 2005, while Hong Kong Stock Exchange (right) flew by an astounding 40 TIMES since 2001!

Figure 7: Yahoo.com: Singapore Exchange and Australian Stock Exchange

On the other hand, Singapore Stock Exchange (left) has returned about 5.5 times for its investors over the past 5 years, while the Australian Stock Exchange (right) has yielded about 4.4 times for investors over the same period.

To recap, secular advancing trends for the Phisix, capital markets development and the ongoing mergers and consolidation trends in global markets merits that the PSE be a part of one’s long term portfolio.

While this is not to recommendation for a buy today, a thawing from its recent sizzling performance could provide an entry point.

Important Disclosure: The undersigned owns shares of PSE.

BSP intervenes to Limit Peso's rise.

Excerpts from today’s Philippine Daily Inquirer on the Peso’s milestone 7 year high (highlight mine)…

``Upbeat foreign investor sentiment perked up the peso Tuesday to a new seven-year high of 44.23 to the dollar before profit-taking and central bank intervention pulled the rate to a weaker finish of 44.31, currency traders said…

``Traders said offshore investors were more bullish than local traders and were quoting the peso at 44.15-44.20 to the greenback in over-the-counter deals, outside the currency exchange Philippine Dealing System.

``The peso would have strengthened further if not for continued dollar-buying by the central bank, Bangko Sentral ng Pilipinas (BSP), on the spot market. However, dealers said the BSP purchases were not as heavy as in previous days as its dealers saw that the market was nearing a correction.

``The BSP purchases were estimated at $100-$200 million. Tuesday’s total volume was $640 million.

``The peso’s extended rally was also supported by a strong regional currency market, which in turn was caused by weak sentiment on the US dollar and by the region’s much-improved economic fundamentals.

***

AS we previously noted, either the BSP tolerates the increase of the Peso or limit or control the Peso’s price movement by means of market operations; by printing pesos to buy the US dollar, where both actions are inflationary, added liquidity into the financial system should further prop the activities in the PSE.

Another notable: in contrast to the suggestion of some experts that the Peso’s rise has been a local phenomenon, instead, as pointed out in the article, the Peso’s rise has been impelled by REGIONAL MOVEMENTS, aside from the plight of the US dollar which means this has been a global financial markets driven phenomenon rather than just plain vanilla economics.

We have earlier seen locals support the Phisix during the latest credit crunch shakeout. Since the breakdown of the US dollar Index to an uncharted low, foreign money has now turned aggressively bullish on the Philippine assets. This turn of events could fire up an accelerated ascent in the Phisix barring any shocks.

Global Equity Markets: “Credit scare, what credit scare…where?”

``Economics is an evolving social science. About the only thing we know when we forecast is that the forecast is wrong. The idea is to get close to the trend if you can. Applying economics to financial markets is humbling. 35 years as a practitioner has taught me to be certain about nothing.”–David Kotok Cumberland Advisors

With the recent strength of the global equity markets one must be wondering; “Credit scare, what credit scare…where?”

Today’s environment certainly makes one feel that markets can ONLY MOVE UP, and that all downside actions be treated only as “ABERRATIONS” or as buying windows. Such dynamics only inflates on our risk taking appetite, fosters undue complacency and propagates overconfidence, the typical ingredients for most investor losses.

The recent credit scare provided the intrepid investor fabulous short term returns opportunities via a “masterful” bottom-picking prowess, where from the privilege of HINDSIGHT we get to see how the recent shocks turned out to be a buying opportunity instead.

But what if such “scare” evolved into a full-blown crisis? What appears to be “adept market timing” could translate to “catching a falling knife”…from bravado to foolishness. In other words, from a BACKWARD looking process since the events had already been perfected, it is then easy to pass conclusions…but, again what of the future? Will markets continue to rise amidst the present litany of risks?

As we have recently gathered, the average investor usually salivates on, or frequently applies “regrets” to such forfeited opportunities, without realizing that DECISION MAKING during these critical moments reflects economic or opportunity costs—cost of an alternative action that must be forgone in order to pursue a certain action (answers.com).

For instance, the credit drought, for us, signifies a SYSTEMIC risk, the first ever real threat to our secular bullmarket. These entanglements in the global financial system could have galvanized into a crisis from which markets could have fallen even more dramatically. Nevertheless, the concerted actions by global central banks appears to have successfully mitigated the present junctures but as to its sustainability remains to be seen.

Considering that effusive liquidity has been our perceived drivers of today’s financial markets, the reversal of such operative presents outsized risks relative to returns which we had been disinclined to underwrite. Hence, our opportunity cost was the supposed “bottom” portion of our valiant risk taker’s “fabulous” market returns in exchange for the relative safety of our capital.

While unlike depression advocates, we persistently argued that any extraneous shocks would affect the local markets in the same manner as it would affect its regional contemporaries, but whose effects could likely be ephemeral--given that the credit, financial market, monetary and economic structures are ostensibly nuanced compared to the epicenter of such shocks. In short, the degrees of functional leverage from which emerging markets and Asian economies have been exposed to are conspicuously distinct from its counterparts in the Anglo Saxon regions.

For us, forecasting depression by parsing trade, financial and economic linkages from HISTORICAL data or paradigms ignores the ever fluid dynamics of the tech-enabled “globalization” evolution quite evidently seen in the financial, economic, political, cultural and technological spheres. Such justification appears to reflect single dimensional thinking in a highly intricate world. Yet in a world where shocks have been mispriced, we simply wouldn’t discount of such possibilities.

Nonetheless, does the prevailing upbeat outlook in the world equity markets indicate that all is well and that potential shocks should be discounted?

Figure 1: New York Times: Sickly Credit Markets Heal a Little as Leveraged Loans Rebound

New York Times’ Floyd Norris gives us a great picture of the conditions of today’s credit market as shown in Figure 1 in his recent article ``Sickly Credit Markets Heal a Little as Leveraged Loans Rebound.”

Mr. Norris’ apropos opening statement (highlight mine), ``THERE are signs of life in credit markets that appeared to be dying only a few weeks ago. But those signs are limited. Few investors have returned, but in some cases banks have stepped in to replace them.”

While most of the credit markets appear to have shown marginally increasing signs of relative composure, they have been quite far from their normal post-credit crunch stance. In essence, these reflect on the continuing strains of investor anxiety.

The most apparent among the improvements had been on the account of leverage loans, where according to Mr. Norris volumes have risen “high enough to allow deals to get done.” This could be one of the factors which underpin today’s rallying US equity markets.

Another, loans have swelled for banks as financing deals which they guaranteed prior to the recent shock had been forcibly added to their books. On the hand, a record surge (fastest rate since early 1974) in the volume of commercial and industrial bank loans, reflects ``leveraged loans that could not be syndicated to foreign banks or investors, but most of it probably represents new loans that in previous months would have been done through the credit market”, according to Mr. Norris. Simply put, the confluences of the lack of diversification from the investors profile plus a recovering market help boosted these volumes of late.

So essentially, the credit markets have moved out of the Intensive Care Unit (ICU) but are still under strict surveillance from the Financial Authorities, given the seriousness of the conditions and the risks of regression. Yet relative to the performances of the equity markets, it appears that today’s market climate has severely underestimated the risks concerns.

US Federal Reserve: Hitting Four Birds With One Stone?

``The Federal Reserve's role in prophesying the future course of the economy, the plethora of new indicators brought to the table to maintain the illusion of science, the secrecy of their deliberations, the ambiguous quality of their utterances, the ascetic nature of the chairmen, the elaborate protocol, is possibly idempotent with Delphi.” Victor Niederhoffer, well known Hedge Fund Manager

As we have noted last week, it appears that there had been a marked shift of market leadership from the directional flows of the US equity markets to the actions in the US dollar.

The recent breakdown of the US dollar to generational lows appears to have bolstered segments of the US markets that has been latched to the global outperformance scenario. Evidences seem to corroborate such theory as supported by the vigorous activities in global ex-US asset classes, surging commodity prices and even the record Baltic Dry Bulk index (indicative of strength of global trade).

This week, as the US dollar recovered some of its lost ground, the sluggish US markets had been propped up by a late robust rally last Friday on accounts of a jobs recovery in the US. Unfortunately, US markets appear to have been “lusting” for any tidbits of favorable news in support of the recent gains, such that the mostly government engineered improvements on the job statistics had been construed as “positive”. As we have said before, the adrenalin in today’s markets have been a function of government steroids.

Our belief is that the US FEDERAL RESERVE could be deploying tools to avoid from the furtherance of policy actions to reduce the risks of resurgent inflationary expectations amidst an economic growth downturn, prompted by the deepening housing recession. The attendant and continuing surge in prices of gold, oil, and other commodities, as well as long term treasuries yields have adamantly reinforced such expectations. Moreover, reduced expectations for additional policy actions could cushion the US dollar from a deleterious unwind.

As we have previously noted, US policy makers have repeatedly shown patent sensitivity to the performances of ASSET prices despite their repeated disavowal “to influence asset prices”. Hence, the apparent aim to implicitly bolster asset prices by indirect intervention, such as the recent spate of injection of liquidity, adjustment of policy rules—allows for a wider universe for eligible collateral and allows for a liquidity pass through from banks to their broker dealer subsidiaries and lowering of interest Fed rates. Aside from pent up activities of the Federal Home Loan Banks to fill up the liquidity vacuum.

You can also add to the list the possible manipulation of the recent employment statistics, where most of its gains came from government hiring, aside from the phantom birth/death ratio which accounted for 69% of non-farm payrolls, according to Paul Kasriel of Northern Trust. Thus, the recent breakout of major US benchmarks (Dow Jones Industrials +1.23% week-on-week, S & P 500 +2.02%, Nasdaq +2.92%) reduces the pressures to apply policy actions and this has started to reflect on FED futures as shown in Figure 2.

Figure 2: St. Louis Fed: Fed Rate Cuts Expectations

As we discussed in our Sep17 to 21 edition [see As The Us Dollar Falls, Stagflation Becomes A Reality], for as long as equity prices remain either on consolidation or on the upside the US FEDERAL RESERVE will likely be on a hold. As in the chart, this view has now generated some following as the gap in Fed rate futures (expectations) have narrowed relative to the actual FED policy rates.

In addition, recent communiqués from some Fed officials appear to give some meat to such outlook, this excerpt from Bloomberg, ``It would be a mistake for markets to bake into the cake the assumption of ongoing rate cuts,'' St. Louis President William Poole said today in New York.”

In short, the FED looks to hit an incredible FOUR BIRDS (not two) with one stone… shore up equity prices, lessen the impact of an economic decline, cushion the US dollar from a drastic fall and reduce inflation expectations. It’s quite an arduous rebalancing task, don’t you think?

In our view, there will be a spillage somewhere, as these delicate and fragile balancing acts by a reaction based bureaucratic leadership will most unlikely attain a Utopian climax. Palliative measures are almost always short term remedies, unless they are providential enough. However, given the FED’s predilections towards targeting asset prices, we are likely to see them err to the side of inflation or blowing more bubbles somewhere.

Anyway, over the broader market, the lagging sectors of the US benchmarks which represents internal woes, have played a catch up role last week, dispelling fears of recession risks. However, with the tidal wave of mortgage resets slated from October to the second quarter 2008 or in the coming 6 months or so, we remain skeptical towards the outlook that the US economy would remain impervious to these developments.

Phisix: Visible Signs of A US Dollar Driven Rally

``However beautiful the strategy, you should occasionally look at the results."-Winston Churchill, ex- Prime Minister and British Statesman (1874-1965)

THE bulls stepped into overdrive as the PHISIX surged for the third consecutive week to expunge ENTIRELY the latest global credit scare triggered losses and to retest its July LIFETIME highs at 3,800.

For the week, Phisix gained a stupendous 5.68% (!), but second only to Indonesia’s 5.99% for a cumulative breathtaking three week winning streak of 13.96%! What a fantastic comeback.

As we have previously discussed, empirical evidences suggests that the today’s captains of the global markets have been the principally fate of the US dollar. In domestic context, such framework applies, as shown in Figure 3….

Figure 3: USD/Peso-Phisix: Reasserting the Correlation

Both the Phisix and the Peso are at decisive junctures. On Friday, the Phisix (black candle) retested its July high at 3,800 and appears to be in the process of reestablishing a new milestone.

On the other hand, the USD/Peso (red line) has successfully broken below its July lows to close at Php 44.75 on Friday.

The chart shows of the negative correlation between the Phisix and the USD/Peso (blue block arrows), where a rising Peso coincides with the strengthening Phisix and vice versa. A caveat is that correlation DOES NOT imply causality.

Our supposition is that aside from monetary policies and trade or remittance flows, the Philippine Peso’s conditions signifies capital flows at the margins, where portfolio flows to Philippine assets meaningfully reflects on the price level of the Peso. The Phisix, being one of the asset classes (fixed income, and real estate), may reflect on such portfolio flows.

For the last two months, however, the said relationship has not been linear. As global markets agonize from the US subprime triggered credit seizure last early August, the Peso and the Phisix fell almost simultaneously, principally on the account of foreign instigated selling.

As you probably noticed, we identified how the Phisix rebounded ferociously and swiftly based on local support. Hence, you’d observe that the Phisix continued its ascent while the Peso struggled.

From September onwards, we observed that the Phisix resumed on its advances with a magnified degree of gains alongside the rise of the Peso. Foreign inflows, however, had NOT been reflected in the Phisix as the month registered a net foreign outflow (3 in 4 weeks!), aside from being relative net sellers (companies which registered foreign inflow-outflow) over the broad market. So, foreign money exchanges could have either seeped through the other assets or got stacked into bank accounts.

As we noted in the past, this has been one of the remarkable “FIRSTs” in the recent cycle, where previously local investors had been seen pushing mainly peripheral issues or on the Phisix issues for only over a relatively limited period of time.

The present recovery revealed of the sustained firepower by the locals, as they directed on the gains of the Phisix or had been responsible for the advance of the “capital intensive” market heavyweights in August through September.

We only saw the reemergence of foreign inflows into the PSE since Friday of last week, and have been inclined to attribute this week’s Phisix’s outperformance to these belated inflows as the US dollar index etched its fresh milestone lows.

Further, we noted in the past of the inherent strength of the local market would come along with the increase in active participations from its constituents. We are already seeing signs of this happening.

As an aside, our long stated notion that Asian money would eventually pour into the region’s capital markets as financial integration deepens combined with a potential realignment of the global capital flows dynamics, in as much as the continued strengthening of the region’s economic linkages.

China’s recent activation of its $200 billion sovereign wealth fund, the China Investment Corp, plus Japan’s potential to do same with Japan Post’s breakup and consequent privatization signifies the idiom of “getting down to the brass tracks” or of getting serious. Combined, these forces, barring any shocks such as resurrected protectionism, would drive the Phisix beyond our 10,000 target in the coming 5 years or so.

For now, the burst of local support has brought about marginal signs of decoupling from the US benchmark as shown in Figure 4.

Figure 4: stockcharts.com: Signs of Decoupling?

As local investors press on to lift the Phisix (candle) from its August lows, we note that the US broadmarket S & P 500 (behind) had been trading sideways, as shown by the circles, to manifest superficial signs of decoupling. Yet, all four benchmarks, the Dow Jones World (topmost) and Dow Jones Asian ex-Japan (lowest window) have been positively correlated.

Our idea is that for as long as the US manages as a soft landing the potential for this soft decoupling on a positive correlation could be maintained. However, if a hard landing occurs the initial reaction could be as destabilizing and almost similar to the July shock except that instead of a short time frame (two months) there could be a potential for a much prolonged torment (possibly a year or more).

Further, because of the lack of objective, comprehensive and in-depth information about valuation based approach to stock market investing, local retail investors have adopted mostly either momentum trading or “event” or “story” based punts which results to a greater number of trades, see figure 5.

Figure 5: Surging Trades Signifies Rise of Speculative Punts

Sellside and technical analysts who proliferate in our industry have heavily contributed to this surge in speculative punts, where little among these practitioners deal with prudent risk management. Only a minority of investors are aware of the cyclical influences of markets relative to the investing exercise of risk-reward trade offs.

Although the rise in the number of trades could serve as a measure for excesses in investor sentiment and signify as a potential tool for market timing, over the long term it would simply be natural to expect the rising trend of number of trades concomitant to an ascending market as investors will intuitively be drawn to winning trends.

Firming Regional Currencies and Revival of Carry Trades Bullish for the Phisix

``Asia’s riches and development, in fact, have been argued by historians to have been the basis for the growth and concentration of wealth and trade in Europe, particularly in Venice and Genoa.”- George Magnus, Senior Economic Advisor to UBS Investment Bank, quoted from the article, Sovereign Wealth Funds and the Rise of the "Global South"

In all, so far with global equity markets as the apparent beneficiaries of a struggling US dollar and a levered play on global growth, seasonal strength going to the yearend, aside expectations of continued global economic and financial buoyancy, liquidity inspired resumption of carry trades and heightened signs of inflation among key Asian economies as China, India and Singapore highlights the prospects for further currency appreciation or a liquidity spillover from unsterilized actions by central banks to limit currency movements.

In addition, even if the Bernanke’s FED were to pause from slashing of its interbank rates, economic growth prospects and interest rate spreads as well as interest rate expectations, are unlikely to be supportive of the US dollar, considering the intensifying losses in its real estate industry.

Except for the excessive investor sentiment against the US dollar, aside from its technically oversold position, the US dollar’s recently could be due to such transient factors.

Meanwhile, the Bangko Sentral ng Pilipinas (BSP) recently reduced overnight bank lending rates by 25 basis points in order to neutralize the implied tightening seen by the streak of the appreciating Peso aside from the possibly reducing the currency’s appeal for carry trade arbitrages, in our view.

Carry trades, or borrowing or shorting currencies with low yields and investing the proceeds into high yielding assets have been reignited on a global scale as the major funding currencies of the Japanese Yen and the Swiss franc has drifted lower amidst the appearance of stabilizing financial markets.

Surging emerging assets, global equities and commodities coincidental to the decline of the funding currencies could be empirical indications of the renewed activities in such specialized highly speculative trades.

A rise in volatility frequently coincides with the rise of these funding currencies as the levered positions utilized by such cross currency arbitrage get closed alongside with the corresponding liquidations of the assets invested.

The Fed’s move to drop interest rates has likewise caused other central banks to procrastinate from normalizing interest rates such as the Bank of England, and European Central Bank. The Bank of Japan is expected to keep on hold its rates too. Remember, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

So the combined policy accommodation seems to have restored the inflationary speculative cycle.

And our thinking is that instead of manipulating the currency movements, the BSP or the local central bank has lowered rates to reduce the yield spread to prevent further appreciation caused by mounting incidences of carry trades.

However, the backstop of liquidity signifying continued strength in the region is likely to diffuse into Philippine assets barring any further credit shocks or deterioration in the US economy.

The short term risk is the technically overbought conditions could lead to an interim correction which should provide us ample opportunities to reposition or reenter.

While we maybe cautiously bullish on the markets over the interim for the abovestated reasons, don’t forget to invest only the amounts of risk you are willing to absorb.

Present conditions, such as a potential hard landing in the US or another bout of credit seizure or ripple effects from a violent US dollar unraveling or a sudden bust in China’s markets, are prone to shocks, whose risks should not be taken for granted.

Present conditions likewise allow us to position to take advantage of short-term trades as well as to position for a longer horizon. Invest prudently.

Global Financial Markets: The Dr. Jeckyll and Mr. Hyde Syndrome

``Historically, the government has kept the Taiwan dollar under a tight reign, so as to deter unwanted appreciation that might harm exporters' competitiveness. In my view, this same policy has hindered the country's ability to develop a robust service sector. Top-tier knowledge workers rarely derive their advantage from a "cheap" currency, but rather from the sheer global competitiveness of their skills and services. Given that such workers can sell their services most anywhere in the world, they have little incentive to reside in a country whose currency policy steadily erodes the purchasing power of their income and savings.” Andrew T. Foster, Director of Research, Portfolio Manager, Matthews International Capital Management, LLC

An 1886 classic by Scottish novelist Robert Louis Stevenson, “A Strange Case of Dr. Jekyll and Mr. Hyde” depicts a tale of a person’s internal “good versus evil” conflict; a personality switch struggle triggered by a scientific experiment which transmogrifies the respectable Dr. Henry Jeckyll into a hideous murderer in Mr. Edward Hyde. The story ends with the dearth of the potion required to bring Mr. Hyde back to his original state or Dr. Jeckyll, where “both” eventually dies.

The financial markets today seem to illuminate of a Dr. Jeckyll and Mr. Hyde syndrome.

On one hand, Dr. Jeckyll appears to be represented by the equities side, which has seemingly been placid and convalescent following the recent bouts of transformation from Mr. Hyde, prompted by the August subprime led shakeout.

On the other hand, the vicious strains of Mr. Hyde have been quite evident in the persistent arterial blockages in the global credit market, the continuing maelstrom in the currency markets and the accelerating perceptions of a sharp economic downturn in the US possibly percolating to the rest of the world.

Where the balancing of the asymmetric conditions of Dr. Jeckyll and Mr. Hyde requires a certain magical potion, its functional equivalent in today’s milieu is the financial engineered credit-driven liquidity structure that has underpinned the sustainability of the current system as shown by derivatives expert, Satyajit Das in Figure 1.

Figure 1: Satyajit Das: The New Liquidity Factory

Mr. Das describes of the transformation of the credit system from the traditional banking driven process to a “borrowing money from borrowed money” structure, we quote Mr. Satyajit Das (highlight mine),

``In the new liquidity factory, investors did the borrowing - hedge funds borrowed against investments; traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.

``The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations - home equity borrowing funded a frantic debt addiction.”

In a pyramid framework, the present liquidity has principally been built from the bottom, where layers and layers of leverages consisting of securitized debt and derivatives comprise the majority of what drives the global financial markets.

The astounding degree of leverage has been estimated as a percentage of GDP and as a share of liquidity distribution by Mr. Das, which implies that the present financial system has increasingly been über sensitive to interest rates, price actions and volatility fluctuations.

The recent perky equity markets adamantly believe that global central banks led by the US Federal Reserve will be able to successfully plug and repair the recently punctured structure as a result of the deepening US housing recession impelled security losses, and the sustain the party.

We hope they are right and Dr. Jeckyll prevails.

Dr. Jeckyll’s Ace: The Rupturing US dollar?

``In capitalist financial markets, discipline and prudence require that investors fear – yes, fear – that they can lose; and lose big time. Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation.”-Paul McCulley PIMCO

However, our understanding is that under the Minsky’s Ponzi finance scheme, credit requires even more credit to ensure rising prices to sustain operations. Hence, the foremost question in our minds…will the global central bank administered potions regenerate enough “velocity” of credit to sustain its momentum and place Dr. Jeckyll as the dominant market personality? Or will its paucity lend to the Stevenson classic denouement?

Meanwhile Dr. John Hussman of the Hussman Funds argues that all the jubilation over the recent expectations of a successful Fed intervention has been downright misleading since he says (highlight mine)``there is no credible mechanism by which Fed actions control the economy.”

Dr. Hussman argues that the investing world bolstered by media needlessly fixates on the sensational and the trivial without propitiously examining the extent of the overall impact of the ongoing transitional process.

We quote Dr. Hussman, ``It's important to emphasize that the impact of these changes is mainly psychological, and outside of a pool of a few billion dollars, won't have any effective bearing on the “liquidity” of the banking system, nor on the solvency of $3.4 trillion in real estate loans, and $6.3 trillion in total bank lending.” See figure 2.

Figure 2: Hussman Funds: The Fed: Magical Fairies and Pixie Dust

From an earlier article Dr. Hussman’s pungent observation anew, ``The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that – typically about one billion dollars – is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window” – though higher than in recent years – still amounts to only about $3 billion.”

In essence, central bank operations including the rate cuts influence only a minor segment of the entire banking based US financial system. His argument separates the forest from the trees, where Central bank operations will likely do little to resolve the current insolvency problems, except that it has and could further influence the market through psychological means temporarily.

But there appears to be a shadow banking system, which we have earlier discussed, in our September 10 to 14 edition [see US Commercial Paper Markets: A Run on The Shadow Banking System?], where as we quoted Paul McCulley of PIMCO, “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures…which may or may not be backstopped by liquidity lines from real banks.” The shadow banking system is tantamount to Mr. Das’ new liquidity factory.

The issue here is one of leverage, where margin based positions have amplified the impacts on the earning quality of assets especially for those thriving on scanty 1-2% returns. Marginal interest rate or price action movements magnify gains or losses for these structures. Ergo, lower rates could be expected to help cushion on the impact of loan losses and higher borrowing spreads.

Nonetheless, could a psychological booster be enough to uphold the Dr. Jeckyll good natured being without backsliding to Mr. Hyde?

The US equity markets, which we believe as the inspirational leaders of the global equity markets, including our Phisix, has substantially recovered following a short episode of a near Mr. Hyde metamorphosis.

For the third consecutive week, US major equity benchmarks has regained most of its losses and in fact is just a breath away from restoring its old glory. Nevertheless, today’s euphoria has been borne out of the continued expectations of the “FED-Bernanke Put” therapy.

Let us scrutinize why US markets have steadily remained upbeat in spite of the cognizance of growing “wall of worries”.

An article from Vikas Bajaj of New York Times, says that the US markets has positioned away from endogenous developments and instead focused on earnings from external factors. To excerpt Mr. Bajaj (emphasis mine),

``The market appears to be buoyed by a belief that the problems in the housing and credit markets will not be severe enough to pull the broader economy into a recession and that growth in Europe and Asia will help offset those ill effects. The optimism is most vividly manifest in the performance of foreign stock markets, particularly those in the fast developing nations like China and India. One widely followed index that tracks emerging markets is up about 24 percent since Aug. 16, when it hit a low point. Markets in developed countries excluding the United States are up about 12 percent in the same time.

``Even in the United States, the market’s return has been led by industries like materials, energy, technology and industrials that investors believe are best positioned to take advantage of the growth in foreign markets. By contrast, the financial and consumer discretionary sectors have lagged because they are seen as having the most to lose from a declining housing market and slowing consumer spending domestically.”

Figure 3: Standard & Poors: Sectoral Performance Breakdown as of Sept 28th

Mr. Bajaj’s observation appears to be accurate enough, as sectors with prominent exposures to world markets or are highly levered to global developments continue to deliver the gist of the gains (see figure 3), particularly Energy, materials, industrials, information technology, and telecoms. About half of the earnings from the large transnational companies are derived from outside of the United States.

In contrast, financials, consumer discretionary, health care, consumer staples and utilities are sectors mostly devoted to internal dynamics hence the recent underperformance brought about by the continuing housing recession and the downshifting pace of economic growth.

Figure 4: Hang Seng Sectoral Performances: Almost the Same Construct As S & P 500

In absence of available data from Japan or from Singapore, due to our unfamiliarity with their websites, the sectoral performance of Hong Kong’s Hang Seng index peculiarly shows of almost the same performance as with the US led by Materials, Energy, Telecoms and Industrial goods. Put differently, macro themes appear to have diffused in diverse markets.

With a tinge of similarity the Philippine Stock Exchange’s aggregate year to date gains of the local indices in pecking order: Mining and Oil + 62.82%, Property +27.82, Phisix +19.79%, ALL index +19.69%, Holding Firms +17.43%, Services +16.73%, Industrials +16.05% and Financials +10.41%.

Now we believe that global growth is only ONE dimension of the entire picture. The other spectrum omitted by the NYT article is the most important operative—the LIFETIME LOW of the US Dollar Index!

With the US dollar trade weighted index losing its purchasing power as reflected by its continued decline against the currencies of its major trading partners (aside from the rest of the world), hard assets as commodities have been steadily gaining in value.

Hence, the expectations of a resurgent inflationary climate as well as investments themes aimed at inflation directed dynamics. Why do you think, materials and energy have been the global best winners of late?

Since commodities are major export products of emerging countries hence, rising commodity values undergirds their export strengths and consequently an important contributor to their economic output.

So it is quite logical that a declining US dollar has fueled a recovery in emerging markets equities (dependent on rising commodities) which likewise powered US large multinationals earnings outlook, hence the strength in the US markets.

On Friday, the widely followed and respected independent Canadian research outfit the BCA Research noted of the snowballing “Anti-U.S. Housing Trades” themes in the…

Figure 5: BCA RESEARCH: Anti US Housing Trades

``Global portfolio investment flows continue to move towards equities, commodities and currencies that are farthest from the U.S. housing market, i.e. away from the epicenter of economic weakness. The relentless slide in the stock prices of U.S. subprime lending companies is ominous for homebuilding stocks. In fact, subprime lenders' stocks hit new lows Wednesday, despite the rally in the S&P 500 index during the past week! Conversely, emerging market equities have completely recovered, hitting a new high. Meanwhile, the dollar continues its steady downtrend, reflecting waning interest in U.S. paper as a consequence of relatively unattractive economic and investment prospects. In sum, the environment is the opposite of the 1990s, when the dollar and U.S. equities were king.”

What goes around comes around. What we used to believe as US inspired equity leadership appears to have now gradated into a US dollar DIRECTED global recovery which seems to have underpinned the US markets of late.

So, could Dr. Jeckyll have found a new ingredient to postpone his day of reckoning?

Maybe. It all depends on HOW the financial markets will respond to a US recession or a credit shock should there be one.

Be reminded that economics is NOT solely the pillar of financial markets or in particular, equity markets. As in the case of Zimbabwe which has suffered successive years of hyperinflationary depression, monetary administration in support of corrupt and perverted fiscal policies has been responsible for destroying its national currency value which subsequently has channeled excesses money creation into stock market speculation, which we dealt in our September 3 to 7 edition [see A Global Depression or Platonicity?]. Even today, the Zimbabwe’s Stock Exchange continues to fly!

In short, Dr Jeckyll’s recipe for sustenance has been and continues to be from:

1. Mainstream expectations that Global Central Banks led by Chairman Bernanke will continue to lean on accommodative policies which focuses on economic growth and forestall a sclerosis in global credit flows while erring to the side on inflation.

2. Mainstream expectations have likewise been grounded on continued global economic strength to offset the slack in the US economy, which should avoid a recession, and/or lastly

3. The UNSEEN driver in the form of a cratering US dollar which could have stoked an inflationary mindset in the global investment community leading to inflation directed investment themes.

Mr. Hyde’s Three Leaf Clover and the Russian Roulette

``Investors and lenders convinced themselves that financial alchemy would turn illiquid securities into liquid securities in all market conditions. But leverage and liquidity require two participants. A borrower needs a lender, and a buyer needs a seller. Otherwise each is just a ship at sea. Liquidity is a human phenomenon, a psychological phenomenon. Investors made the mistake of believing that financial technology had repealed the laws of human nature.” -Michael Lewitt, Hegemony Capital Management, Vectors of Credit

So markets have essentially been rising on the account of global rescue packages deemed as inflationary, but Mr. Hyde maintains his presence felt in the financial system amidst such perky expectations.

Here are some signs that Mr. Hyde still lurks in far corner waiting for the right opportunity to pounce:

A continued rise in interbank lending rates as shown in Figure 6…

``The London interbank offered rate that banks charge each other for overnight loans in pounds rose 20 basis points to 6 percent today, the highest in 10 days, British Bankers' Association figures showed. The corresponding rate for dollars rose 21 basis points to 5.30 percent, and the euro rate climbed 6 basis points to 4.23 percent.” September 27^th Bloomberg,

Figure 6: stockcharts.com: Widening spreads signs of tranquility?

While some semblance of restoration of order has been seen in the credit markets, widening spreads have not been encouraging signs of tranquility.

ECB Banks continue to tap emergency funds…

``The European Central Bank’s emergency lending fund, which attracts a penal interest rate, was tapped on Wednesday for €3.9bn, the largest sum since October 2004, the Frankfurt-based institution has revealed.

``The surge in demand for the ECB’s “marginal lending facility” points to the difficulties still being faced by European banks as a result of the global credit squeeze.” September 27^th Financial Times

Again from Dr. Hussman’s perspective, the amount broadcasted by media as accessed by banks is basically miniscule compared to the overall securities affected by the recent credit gridlock.

And in Canada, paralysis continues in the short term funding for Asset Back Commercial Papers market (ABCP)…

``The Canadian cash crunch that started with defaults on subprime mortgages in Southern California and Florida has hurt more than 25 companies that invested in commercial paper, including Sun-Times Media Group Inc. and Canada Post, the nation's mail service. Baffinland has 95 percent of its cash in Canadian commercial paper, debt that is due in 364 days or less.

``Investors fled Canada's asset-backed commercial paper, paralyzing the C$40 billion market for debt that carried the highest credit ratings, after losses from home loans to people with poor credit histories roiled global credit markets.” Bloomberg September 25^th

In the US, Commercial Paper Markets continue to shrivel…

``The U.S. commercial paper market shrank for the seventh straight week as the Federal Reserve's interest rate cut fails to improve conditions for short-term credit.

``Debt maturing in 270 days or less continued its biggest slump in seven years, falling $13.6 billion in the week ended yesterday to a seasonally adjusted $1.855 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington. The week's decline is smaller than the previous week's drop of $48.1 billion, a sign that buyers are starting to return to the market after the Fed's half-point reduction Sept. 18 in its benchmark interest rate.” Bloomberg September 27^th

In contrast to the news presentation, a smaller degree of decline is no evidence that buyers have emerged.

Moreover, credit paralysis has been a worldwide phenomenon, now with its tentacles reaching Russia…

``Overnight lending rates in Russia climbed to 10 per cent, the highest since mid-2005, even after the central bank on Wednesday pumped an additional $2.56bn into the banking system via two one-day repo auctions. Traders and bankers said the spike came as companies and banks prepared to make a monthly round of tax payments and primed their accounts to meet central bank requirements in time for end of third quarter financial reports…

``The Central Bank was also forced to pump liquidity into the system via repo auctions at the end of August after foreign investors fled Russian money markets amid the flight to quality following the US subprime crisis and tax payments fell due. Russia racked up more than $5bn in net capital outflows in August.” September 26^th Financial Times

Notwithstanding, the bleak outlook from the IMF suggesting the credit driven volatility will most likely continue to affect the global financial systems….

``The global financial system has undergone an important test and the test is not over yet. Implications of this period of turbulence will be significant and far-reaching," Jaime Caruana, IMF director for monetary and capital markets departments, told a news conference…

``IMF Managing Director Rodrigo Rato said the impact on global growth from the credit crunch and re-pricing in credit markets will be felt in 2008 and that the United States will most likely be hardest hit.

``He said world economic growth should remain strong next year but looks set to be below the levels of 2006 and 2007 and downside risks increase the longer financial markets remain in crisis, Rato told a seminar in Madrid.” September 24^th Reuters.

Telegraph’s Ambrose Evans Pritchard says that US leading investment broker Goldman Sachs, previously a key proponent to the global decoupling theme, appears to have been proselytized to camp of the bears…

``Goldman Sachs has abandoned its ultra-bullish view of the world economy, warning of a likely recession in Japan and mounting risks that US property slump could spread to parts of Europe.

``In a new report, "The Global Economy Hits a Crunch", the US investment bank said it was no longer sure that Asia and Europe would be able to pick up the growth baton as America stumbled. It fears that turmoil is spreading beyond the debt markets to the factory floor.”

In short, Mr. Hyde still has a commanding presence that may shift the war of psychology in his favor with three apparent risks variables at play…the prospective escalation of the credit bottlenecks, a US led economic recession percolating to a global slowdown and a chaotic unraveling of the US dollar.

To say that Central bankers appear to have successfully cleared the hurdles as evidenced by the rising markets is analogous to playing the “Russian Roulette”…

Just because the first two shots were fired and you survived does not imply the revolver’s 4 remaining chambers are not loaded.

Gold: Surging Across Diverse Currencies! Policy Responses Should Favor Present Momentum

``When the Central Bank sells assets to the banks or the public, it lowers bank reserves, and causes pressure for credit contraction and deflation—lowering—of the money supply. We have seen, however, that governments are inherently inflationary; historically, deflationary action by the government has been negligible and fleeting. One thing is often forgotten: deflation can only take place after a previous inflation; only pseudo-receipts, not gold coins, can be retired and liquidated.” -Murray Rothbard, What has Government done to Our Money

For some, the rise in gold prices is just a normal function of markets and should be cheered about.

For us, rising gold prices, especially on a worldwide currency scale such as rising gold price in EUROS (!) see Figure 7 (and against most major currencies…except the Canadian dollar), evinces strains in the global monetary frontiers and do not represent an optimistic outlook. Therefore, we find metals and metal related assets as an instrument of hedge. (I have been saying this since 2004)

Figure 7 James Turk’s Goldmoney.com: Gold rising in Euros

As we have long argued, we believe that further strains in the financial system would lead policymakers to an almost perpetual loop for political treatment based short term solutions, whose actions includes effecting rescue packages for its constituents (banks) at the expense of the general population by debasing its currency.

Such is the natural inclinations provided for by the Fractional banking system, the functional operating system of today’s Fiat Currency Standard.

Political pressures like those applied by media--imagine the unnerving sight of snaking lines of depositors during a bank run similar to those of UK’s Northern Rock--which politician will not be prompted to act on the behest of the protecting depositor’s welfare simply because they represent significant number of votes? Otherwise be seen as insensitive and irresponsive incumbent bureaucrats.

Besides, inflationary mechanics have never been truly understood by the public, whom are mostly obsessed with short-term gratifications (the Philippine Senate hearings should be an example), which is why inflation is a favored tool by politicians and their factotums (think interest rate and currency manipulations, gold sales and etc…)…a concealed tax.

Paper money has been founded on mere trust on the government’s ability to repay its obligations. Whereas history tells us that governments in any forms unbacked by the gold standard almost always steal from its constituents by repaying debt in devalued currency, if they ever repay at all (or by default).

On the other hand, Gold is no one’s liability. In the words of the great Ludwig von Mises (highlight ours), ``The gold standard has one tremendous virtue: the quantity of the money supply, under the gold standard, is independent of the policies of governments and political parties. This is its advantage. It is a form of protection against spendthrift governments.”

The steep decline in the US dollar mirrored by the rise of gold prices simply suggests to us that there could be a countertrend or correction soon, as no trend goes in a straight line. Yet the chances of an auspicious momentum, for a sustained run perhaps until the yearend, seem to look good for our alternative money. A gold price of $800 target to $850 looks attainable GIVEN THE SUSTAINABILITY of the present conditions.

Nonetheless, we also see the US bellwethers in the Dow Jones Industrials 14,000 and S&P 500’s 1,555 as important barriers. Failure to surpass previous highs could potentially mean a retest of its August lows otherwise we could see a consolidation. However, it is quite interesting to see if the NEW DYNAMICS will be sustainable: the falling US dollar supported buoyancy in US equities or if the “anti-housing trade” should help US equities higher.

The fate of Emerging markets will similarly respond to the direction of the US dollar index. These cross currents have given us some clues as to where the long term trend is likely to proceed. We will position accordingly.

Yet given the risks scenarios, we shouldn’t discount financial shocks.

However, the odds favor that policy responses will be tilted towards ensuring the safeguards of the financial institutions and the preservation of the present monetary system, despite the mounting pressures for its unraveling in the distant future (postponing the day of reckoning).

Post-US dollar breakdown and gold breakouts…

Stay long gold, Mines and Asian Currencies!