Amusing Video From Slate Magazine: Buy America!

Amusing video from Slate Magazine...

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The recent economic downturn may be bad news for Americans, but for foreigners with money to burn, editorial cartoonist Mark Fiore knows of a certain well-known superpower that's available for a song.

Phisix: On A Bear Market Template, Bear Market Rules Apply

``The failure to understand the dynamics of market cycles is a major reason why investors repeatedly overextend their risk near market peaks, hold onto their stocks over the full course of a bear market, and finally abandon stocks near market troughs. Though less than half of a typical bull market's gains typically remain by the end of a bear market, those bear markets rarely move in a straight line. Instead, they typically include several declines of 10-20%, punctuated by very hard rallies. As I've noted before, the 2000-2002 decline, which took the S&P 500 down by nearly half, included three separate advances of about 20% each (measured from intra-day low to intra-day high). These advances serve to keep investors “holding and hoping,” as Richard Russell would say.”-John Hussman

It is rare to have our projections (namely, oversold bounce, a rush of government policies, record high gold) come to pass immediately, as most of the time they take “eons” to transpire. But we won’t have to “pat ourselves in the back” over these short-term favorable outcomes because events may turn out to be fleeting.

In the ongoing epic struggle between market forces, manifested today by the adjustments brought about by debt induced deflation, and inflationary government intervention, signified by “safety net” policies aimed at cushioning its impact, the convulsive tensions from such conflict could be clearly felt in the markets. Tuesday headlines “Stock Market Plunges Worldwide” (Associated Press) was a clear depiction of such phenomenon.

As I have posted in my blogspot last Monday, “Phisix, Most Global Markets Enter Bear Territory” over HALF of the world’s indices has transitioned into bear markets as identified by Bloomberg, which included our own Phisix, shown in Figure 1.

Figure 1: stockcharts.com: Global Markets: Transition To A Cyclical Bear Market?

Technically, a bear market is defined as a drop of 20% from the top. And the underlying characteristic of bear markets is it “descends upon a ladder of hope” or that momentum implies the path of least resistance is likely to be a downward path. In short, expect negative returns. The paramount question is how deep and for how long?

For the Phisix, which as of Friday’s close is down 16.4% from its pinnacle last October, this highlights the second attempt to breach the psychological barrier of 3,000, but again due to oversold levels, the Philippine benchmark has violently recoiled and erased some of its losses (see Figure 1 main window). Again, data from PSE indicates that these intense selling could be attributed to the streak of massive net foreign selling since the advent of 2008.

Of course, we don’t deny that domestic dynamics has been tied to the events around the world, as we have been one of the “rare” contrarian iconoclast preachers of globalized correlation since 2003-when everyone was talking “micro”, although again we think that market dynamics could be shifting to “regional” than “global” in the near future (again another of our contrarian theme).

One remarkable observation today is that the Phisix has performed almost at par with US markets instead of suffering from severe drubbings of a far greater degree as seen in the past.

For the US markets which has served as an instrumental leader for global markets, 2 of its major indices like the Phisix crossed over into bear territories during the last week’s carnage but have regained some of its losses, namely the technology rich Nasdaq (down about 18% from its peak as of Friday) and small cap Russell 2000 (down 19%). On the other hand, the Dow Jones Industrials is down close to 14% and for the S & P 500 nearly 15% (upper pane in Figure 1).

All this implies is that our Phisix has now been transformed into a relative Beta play or near equal volatility with that of the US markets. Of course we expect this to change which we will elaborate later.

For the moment, the reappearance of risk aversion in the form of bear markets hound even emerging market stocks as represented by Asia ex-Japan (upper pane below center window) down about 17% and iShares Emerging Markets (lowest pane) down 19%-as of Friday’s close.

But with the realization that the direction of equity markets seems to have gradated into a bear market requires a new template for one’s portfolio management. In other words, some trading rules for surviving bear markets, Carl Swenlin of DecisionPoint.com gives us some great clues (emphasis mine),

``Oversold conditions should be viewed as extremely dangerous. Whereas in bull markets oversold lows usually present buying opportunities, in bear markets they can often resolve into more heavy selling.

``Overbought conditions in a bear market are most likely to signal that a trading top is at hand.

``While bear market rallies present great profit opportunities, long positions should be managed as short-term only.”

To translate for market participants of the Philippine Stock Exchange: The next attempt to successfully infringe on Phisix 3,000 could lead to a test on the next critical support at 2,550 possibly over the medium term (perhaps 3 months to one year).

Albeit, we don’t want to be too mechanical about this or depend stringently on such rigid technical outlook, because, it is of my view, that fundamentals will dictate on the markets in the succeeding events where the next series of downturns in Anglo Saxon markets will be met with lesser degree of declines in the Phisix or even a potential divergence.

But again under present conditions bear market trading rules should apply unless the Phisix reveals of prominent signs of divergences.

Emerging Markets and the Philippines: The Last Shoe to Drop?

``The current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”-George Soros, The worst market crisis in 60 years

Global depression advocates were in boisterous gaiety following last week’s synchronized global equity carnage and used such occasion to pontificate and bash the topical “decoupling” paradigm as preposterous, a myth or a figment of imagination.

In our view, such “know-them-all” outlook ignores the general circumstances of the unfolding war of attrition between the forces of inflation and deflation, where the present episode of a battle won is unduly justified as equivalent to a final victory in war.

Yes, we agree that market forces will eventually undo every government induced imbalances, but the world is more complex than is commonly assumed even by these experts.

Austrian Economist and 1974 Nobel Laureate awardee Friedrich Hayek in Individualism and Economic Order explains of the dynamics of changes which emanates from the individual level, ``For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since only the tastes and not the actions of individuals can be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other peoples' actions, there is no reason why these processes of successive changes should ever come to an end.”

Put differently, an individual’s response to the conditions which one encounters differ from the response of other individuals, and these separate responses underpin such “change” dynamics which makes it hard to qualify and quantify. Thus, if a community of individuals has different reactions to variable conditions, could we be assured that the deduced proximate causal relationship based on the different levels of economic and financial interdependence as opined by experts lead to the same distribution outcome? Can we also expect of the same responses from government officials in the face of divergent political pressures?

In the recent past when developed economies as the US suffered from “shocks”, emerging markets bore the brunt of such radical adjustments, as shown in Figure 2, courtesy of IMF’s Global Financial Stability.

Figure 2: IMF Global Financial Stability Risk: Improving Performances of Emerging Market Assets

This is an important picture: notice that during the last 3 minor selloffs in the US markets prior to the July credit squeeze, which ranged around 5-7% (rightmost graph), namely in April-May 2004, May-June 2006 (Yen Carry Unwind) and February-March 2007 (Shanghai Surprise), the degree of the losses accounted for by emerging markets (leftmost graph) had been thrice as high at the start (2004 and 2006), but has considerably lessened (2007).

In short, the volatility trends in emerging markets has seen tremendous improvements relative to its Beta coefficient; the previously HIGH beta was cut by almost half in February 2007 when compared to the losses in the US S & P 500.

Today’s turbulent markets reflect the same improving dynamics. As earlier stated, the S & P 500 has lost 15% as of Friday’s close while the Phisix is down 16% from its peak and so with emerging markets (EEM) at 19%. If the same volatility had been applied relative to its 2004 and 2006 scale, then emerging market benchmarks and the Phisix would have caved in by about 45%!

Yes, we remain undoubtedly “coupled” to the US markets yet, but “recouplers” are “reading the tea leaves” from too much of only one facet of the “interrelated” global asset class.

Go back to figure 2 and I’ll show you more. In between the S & P 500 and the MSCI emerging market equity benchmark are three other benchmarks, respectively, external debt (EMBI Global), Local currency debt (GBI Emerging Market) and currency.

The same marvelous progression dynamics with the equity markets can be said of these asset classes except that…

Figure 3:asianbondsonline.com: Philippine Bond Yield on Major US Issues (left) and 2 year and 10 year Local Currency Yield (right)

…unlike in the past where emerging market equity volatility led to equivalent losses but at a very much mitigated degree, today’s volatility has even accounted for surprising gains (!), (read my lips G-A-I-N-S) -if one reads into the Philippine markets as a possible representative of the emerging markets.

Figure 3 courtesy of ADB’s asianbondsonline.com shows that bond yields of Philippine papers in both local currency issued sovereigns (left) and US dollar denominated sovereigns (right) are presently LOWER. Since bonds yields and prices are inverse, this means bond prices have been climbing HIGHER a year on year basis. In short, positive returns amidst a negative equity market landscape. The same holds true if compared with the JP Morgan Emerging Debt (JEMDX) funds on the same timescale.

Figure 4:asianbondsonline.com: Peso-US Dollar/ Peso Japanese Yen

Again if one looks at the Philippine Peso we see the same mechanics at work. The Philippine currency amidst the global turmoil continues with its winning streak, not only relative to the US dollar, in spite of the April-May 2004, May-June 2006 (Yen Carry Unwind), February-March 2007 (Shanghai Surprise), July-August 2007 (global credit squeeze) and today’s US recession concerns, but has also risen against the Japanese Yen as shown in Figure 4. This even comes in the face of a lower growth rate of the much ballyhooed Peso driven OFW remittances in November (inquirer.net).

Although we may not be bullish on the Peso relative to the Yen (global volatility should lead to possible repatriation Japanese money invested abroad which could mean rising Yen and a lower Peso), the point is global financial markets appear to be pricing in a market beta of “muted convergence” (a.k.a. recoupling) for the emerging markets ONLY in the dimensions of the equity markets!

Of course the markets may again rule against my outlook as in January 11, [see Windshield Outlook: NO Signs of Global Depression], but until we see these happen again, present trends appear to signal emerging market resiliency than weakness.

How can these not be, where US markets have been reeling from the heat of potential credit rating downgrades of key corporations, including major bond insurers as discussed last week (yes-more US taxpayers money coming- New York Insurance Superintendent Eric Dinallo to the rescue?) (cnnmoney.com), on capitalization, losses and lower earnings concerns, the Philippines has recently been stamped with good seal with an accompanying credit ratings upgrade from “stable” to “positive” from Moody’s (inquirer.net).

Further, recency bias had been exhibited by some ivory tower ensconced experts as highlighted by mainstream media, following the recent thrashing in the domestic equity markets. According to an alleged expert, one of the main risks of the local economy is that Business Process Outsourcing (BPO) will endure job retrenchment from a US slump. Huh? We don’t follow the logic.

The major reason, according to C/Net.com, why companies outsource some of their work is due to cost-cutting. A slump in the US will prompt for more cost-cutting measures, which possibly means more prospective outsourcing, not less. Remember the Y2K problem or the Millennium Bug Crisis of 2000 (news.com) in tandem with dot.com crash helped fueled the Indian-led outsourcing boom we are witnessing today.

Bottom Line: one of these markets will definitely be proven wrong soon. Will there be an emergent divergence in the global equity markets? Or, will emerging market bonds and currencies collapse under the weight of US-UK-EURO deflationary selling pressure?

The man who broke the Bank of England in the 1990s in the person of billionaire philanthropist George Soros (Financial Times) recently wrote, ``Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.” (highlight mine)

A bank analyst recently asked, ``will emerging markets be the last shoe to drop?”

Bernanke’s Financial Accelerator At Work, US Dollar As Lifeblood of Globalization

``There is no sign that underlying need to sell US assets to the Chinese government to finance the US current account deficit is about to go away. China’s government isn’t buying US assets to help finance a period of adjustment that will ultimately reduce the United States dependence on Chinese flows. It is buying US assets as a byproduct of a policy of trying to defer adjustment.”-Brad Setser

One of the main reasons we argue against the supposition of a global depression or even downplay the odds of a world recession in spite of a potential US hard landing is on the assumption that monetary policies from the US will have different impacts to different countries, especially to those whose currency regime remains tied to the US.

In a recent note to a favorite client, I wrote, ``If there is any one-single most important link to globalization, it is not exports, reserves, capital flows or remittances, it is the US dollar standard system. Since most of the trade or capital flows, which shapes trading patterns and cross border flows influences a nation's economic and monetary structure, are conducted still in the US dollar, US policies (fiscal and monetary) will continue to be asymmetrically transmitted to the rest of the world. As to its unintended effects is one matter to reckon with and speculate on.”

Why do we say so? Because the Paper money-Fractional Banking system which underpins the US dollar standard is the major artery network which serves as the lifeblood of today’s global economy. In the words of Friedrich A. Hayek in his “The Paradox of Saving,” (emphasis mine) `` So long as the volume of money in circulation is continually changing, we can not get rid of industrial fluctuations. In particular, every monetary policy which aims at stabilizing the value of money and involves, therefore, an increase of its supply with every increase of production, must bring about those very fluctuations which it is trying to prevent.”

So in effect, the manipulation of money and credit growth brings about distortions and imbalances in the real economy. But since today’s real economy involves the participation of most countries in the globalization phenomenon albeit at varying degrees, then the consequences of such imbalances will be reflected on a global scale but is whose to impact domestic economies would likely be at diverse levels.

Figure 5: Bank of International Settlements: Credit, Asset Prices and Monetary Policies

Figure 5 from the Bank of International Settlements (BIS) shows of the divergent scale and scope of the world’s regions relative to its exposure to credit, real policy interest rates, real property prices and consumer price inflation.

In other words, the chart zooms in on the vulnerability of each region to the risks of an asset busts which could influence their underlying real economies. Thus, we find the Industrial countries (upper left) followed by Central and Eastern Europe (upper right) as the most risk prone relative to the indicators: credit to GDP and property price trends. Notice too that real policy rates (green line) have been drifting on a downtrend to near zero levels for all regions which has underpinned growth in the asset markets (property prices).

Yet, following the emergency US Federal Reserves 75 basis point cut last Tuesday, the single biggest cut since 1982, and the first emergency cut since 2001 (cbsmarketwatch), these real policy rates are likely to plunge to negative levels and could possibly ignite further inflationary pressures in different areas not affected by the credit crisis.

For instance, countries whose monetary regimes that are tied to the US dollar via a currency peg like the oil revenue rich GCCs or China risks more inflation. And the speculative momentum brought about by expectations of a break in the currency regime or a substantial revaluation will likely attract more speculative influx into their assets.

Yes admittedly, GCC bourses have lately been affected by the turmoil in the equity markets pricing in the concerns of a US recession but it is too early to impute on the superiority of the transmission effects of a US slump over negative real rates brought about by the Bernanke Put. Zimbabwe should be a timely reminder of policies gone awry and whose unintended effects are reflected in the currency exchange value and the stock market.

As we always love to quote Ludwig von Mises (highlight mine), ``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

To our mind, voluntary abandonment of credit expansion is unlikely the scenario given the existence of Central banks whose implied fundamental task is to inflate the money and credit system.

Further, any additional actions to reduce rates by the US Federal Reserve and other safety nets via fiscal response will give further emphasis to such glaring discrepancies in the global monetary system. This is likely lead to more boom-busts cycles.

Nonetheless, the urgency of action undertaken by the US Federal Reserve has prompted for a debate on Fed Chairman Bernanke’s alleged “undeserving” sensitivity to the predicament of Wall Street and thus being hoodwinked by a 31-year old rogue trader Jérôme Kerviel from Société Générale (newyorktimes), who reportedly burned $7.2 billion of the company’s capital from unauthorized trades, to unduly trigger an emergency response from the Ben Bernanke’s Fed.

Such assertion gives Mr. Kerviel undue credit for being able to force Chairman Bernanke’s hands.

We don’t know about the exact chronology of events but global markets have already been in a steep decline even before Monday’s selling pressure.

Besides, Asian markets opened the week with massive losses even prior to the opening of markets in Europe. Hence, while Société Générale unwinding of Mr. Kerviel’s losing illegitimate positions may have influenced the momentum for further selling, it is unlikely to have been the cause. In fact, the US markets, despite the emergency rate cuts and proposed policy responses over the week by the Fed, President Bush and the Congress combined, fell significantly on Friday.

Third, as discussed in November 12 to 16 edition, [see Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts], Bernanke’s speech last June 15 on the Financial Accelerator was a dead giveaway on his policy responses.

Again from Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

What we wrote then (emphasis mine),

``Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.”

Oops, looks like a bullsye for us.

From our point of view, Mr. Bernanke would have done the same even without Mr. Kerviel’s tomfoolery. It is thus far the fear over the unquantified degree of losses in the banking system spreading over to the real economy that is weighing on the financial markets, hence markets will respond accordingly.

Besides, if indeed Mr. Kerviel’s misdeeds did mistakenly trigger an undue reaction by the Fed, this should be revealed by the next FOMC meeting at the end of the month. The Federal Reserve is likely to hold rates under such circumstances, albeit we will go by Bernanke’s operating principle as basis for anticipating on his next policy response.

Phisix, Most Global Markets Enter Bear Territory

A Technical definition of a Bear Market is when benchmarks decline by 20% from its highs.

Today’s huge 5% decline brings the Phisix officially to bear territory.

We aren’t alone though. Half of the global markets are in bear territory following yesterday and today's carnage. According to Bloomberg,

"More than half of the world's biggest stock indexes fell into a bear market as mounting concern about a U.S. recession dragged down banking and retail shares across Asia, Europe and Latin America.

“The MSCI World Index's 3 percent decline yesterday, the steepest since 2002, left benchmarks in France, Mexico, Italy and 35 other countries at least 20 percent below their recent highs. Declines today turned Indonesia, India, the Philippines, Taiwan and Thailand into bear markets as well...

“Among 80 equity national equity benchmarks tracked by Bloomberg, indexes in Argentina, Australia, Austria, Belgium, Bulgaria, Chile, Colombia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Hong Kong, Hungary, Iceland, India, Indonesia, Ireland, Italy, Latvia, Lithuania, Luxembourg, Mexico, Namibia, the Netherlands, Norway, Peru, the Philippines, Poland, Portugal, Romania, Singapore, Spain, Sweden, Switzerland, Sri Lanka, Taiwan, Thailand, Turkey, Venezuela and Vietnam have also dropped at least 20 percent from recent highs.’…

“Fed funds futures show that 72 percent of traders expect the Federal Reserve to cut its benchmark rate to 3.5 percent from 4.25 percent on Jan. 30. Banks and consumer stocks have failed to recover even after policy makers lowered the target rate for overnight loans between banks three times since September from 5.25 percent."

Banking System’s Conflict of Interest Should Underpin Gold’s Rise

``O gold! I still prefer thee unto paper which makes bank credit like a bank of vapour.”- Calvin Coolidge (1872-1933), Thirteenth President of the US (1923-29)

As we have earlier said, present market actions denote of ongoing deflation of several asset classes brought about by the massive deleveraging in the US banking system. For instance, the rapid decline of gold prices has been lauded by global depression proponents as working in favor of their cause, see figure 4.

Figure 4:stockcharts.com: Gold and Oil Still Intact, Yen and US dollar bottoms

Depression advocates argue that the prevailing deflation momentum in the US will overwhelm the world and set forth a chain of global financial market meltdown and economic reversals. We do not buy such apocalyptic theory (as discussed last week).

True enough, deflation is having its field day as the rising Japanese Yen (lowest pane) signifies the deleveraging of the global carry trades amidst last week’s carnage, while the bottoming signs of the US dollar index (upper pane below center window) possibly represents the stampede towards the hoarding US dollar and US dollar denominated-US treasuries.

Incidentally debt deflation is a manifestation of the painful adjustments by market forces on the massive imbalances imposed into the system by the accrued colossal distortions of inflationary activities shaped by government activities over an extended period of time. On the other hand, the inflationary forces are simply the redistributive policies enacted by policymakers to appease the voting public or special interest groups to perpetuate themselves in political power.

For us, while deflation seems to be at the edge today, the present turmoil signifies only an episode of an epic ongoing battle between market forces and government activities.

For instance Martin Wolf columnist for the Financial Times in an outstanding piece “Regulators should intervene in bankers’ pay”, wrote why bankers appear to be distinguished from the rest of the field we quote (highlight ours),

``No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble…

``It is the nature of limited liability businesses to create conflicts of interest – between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

``That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation.”

While Mr. Wolf believes that the solution to this is to regulate bankers pay in order to align it with their accompanying incentives, our thoughts is that the major culprit, aside from those indicated (which are more reflective of symptoms than causes for us), is the present monetary system-the US dollar standard operating under the Fractional Banking system-whereby the conflict of interest paradigm emanating from a “limited liability businesses” is best exemplified.

Central bankers are designated for social tasks; to ensure price stability and generate maximum employment (a.k.a. inflation). On the other hand private bankers undertake risks to generate profits. But since the underlying privilege of private bankers-as primary agents or conduits for Central Banks-hence the issue of limited liability businesses emerge out of divergent incentives.

To quote Ludwig von Mises in Human Action, ``Bureaucratic conduct of affairs is conduct bound to comply with detailed rules and regulations fixed by the authority of a superior body. It is the only alternative to profit management. . . . Whenever the operation of a system is not directed by the profit motive, it must be directed by bureaucratic rules.” (emphasis mine)

In essence, when you combine the role of private and public interests you have natural case of conflicting incentives, easily known as the agency problem or principal-agent problem.

Since our extant monetary system operates under the unique arrangement between Central banks and private bankers (Central banks cannot afford the banking system to go under hence the subsidy), the latter conducts risk-taking activities under the assumption of “limited liabilities” or implied “subsidies” or the knowledge “socialization of losses” from their political patron, given their indispensable role.

Notwithstanding, the worsening conditions in the US banking system today, such dynamics underpins the crucial relationship [as per Martin Wolf…only businesses able to devastate entire economies…no other industry is uncertainty so pervasive…no other industry is it as hard for outsiders to judge the quality of decision-making] from which should lead to more subsidies or “socialization of losses” disguised in variant forms, even when some of them declaim such as “Moral Hazard”-for us a PR stint. Under such premises, gold prices will likely continue to flourish as global policymakers continue their currency debasing activities.

Thus, we believe that gold’s recent decline is likely a countertrend reaction to its recent surge more than a sign of “depression”. By depression we mean a prolonged agonizing period of recession.

Figure 5: US Global/Moore Research: Seasonal Activities in Gold Prices

In addition, Figure 5 illustrate to us that the present actions of gold could also signify seasonality. Gold tends to peak during the first quarter, then tapers of until the third quarter before resuming its upside.

Third, following gold’s latest feat of achieving record nominal milestone highs, gold’s decline could also represent the issue of popular-crowded trades.

Since mainstream media has finally caught up with the gold fever with such commentary from Financial Times, “Gold is the new global currency”, momentum, speculative and retail investors tend to crowd in on fashionable themes.

Moreover, crowded trades appear to have piled in as shown in Figure 6.

Figure 6: Rude Awakening: Sell Gold!..or Buy it

This from Eric Fry from the Rude Awakening (underscore mine)

``Gold's price has been soaring recently, and so has its popularity, especially among the "Speculators" in gold commodity futures. According to the latest Commitment of Traders Report from the CFTC, the Speculators – also known as the "dumb money" – are holding a record-high, net-long position of 220,000 gold futures contracts. For perspective, that's double the position this group held six months ago and four times the position they held two years ago. For additional perspective, the Speculators held their record-high, net-short position on April 9, 1999, shortly before gold launched its dazzling run from $280 an ounce…

``It is worth noting, therefore, that while the Speculators are flowing into the gold market, the "smart money" Commercial traders are ebbing. The "Commercials" are holding their largest-ever net-short position in the gold market. In other words, they are betting heavily against rising gold prices. By contrast, back in 1999, the Commercials were taking the other side of the Speculator's big bet against gold. In April of 1999, the Commercials held their largest-ever long position in the gold market, just before the gold price took flight.

In short, technicalities, sentiment, overcrowded trades and seasonality factors could weigh against gold over the short term. But again we won’t count much on these as governments are likely to intercede and continue measures aimed at mitigating the circumstances of the public via “safety nets” (for political reasons) or to “socialize losses” for special interest groups even at the extent of some possible sacrifice among their constituents.

Bottom line: Today’s monetary standard depends on the operating principle of the privileged “Fractional Banking system: Central Bank-Private Bank” arrangement where authorities will likely fight to preserve the status quo, even if they require socializing more losses for its upkeep at the expense of the general public. This should be good for gold.

As an aside, depression advocates could end up being right for the wrong reasons: Collective Central bankers (mostly Keynesians) could proselytize into Austrian economists and allow for the maladjustments in the system to run its course without government interference despite the public’s outcry. Or perhaps war or protectionism overcomes globalization trends. The latter of which seems to be a more credible risk.

Figure 7: Prieur Du Plessis/GaveKal: Gold’s Rise has been correlated with the China’s surging Purchasing Power

Finally the chart from Gavekal shows how the explosive growth of Chinese purchasing power (measured through wages) has been correlated to surging gold prices.

No, this is not to suggest that China’s buying patterns has been responsible for the recent surge in gold prices to record highs, but it does show how Chinese consumption as the fourth largest consuming country, which accounted for 9.2% of worldwide global consumption (Forbes) has played a modest role in its turbocharged performance.

It also implies that as the Chinese grows wealthier the likelihood is that gold consumption will likewise reflect the rise of its purchasing power.

Portfolio Management Under Today’s Stressful Market Environment

A Premature Call or One Week Does Not a Trend Make?

``The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”-Joan Robinson, Cambridge University (1903-1983)

Hardly has the ink dried from our last outlook, when financial markets across the globe started falling apart. Could we have spoken way too soon?

Worst of all, what we asserted as possible seminal evidence of financial market “decoupling” got slammed, as shown in Figure 1.

Figure 1:stockcharts.com: Global Markets Cracking UP?

The Philippine benchmark, the Phisix (center window) suffered its worst single week loss steeply down 9.57%, since the week that ended August 16 in 2007. Year to date the Phisix, prompted by a streak of intense foreign selling, has lost 12.52%, with barely a month into 2008!

Worldwide, most of the reactions have been the same, the Dow Jones World Index (above pane), the Fidelity Southeast Asian Fund (pane below center window) and the Templeton BRIC Fund (lowest pane) all showing a technical breakdown from critical support levels.

Again, with the exception of benchmarks Gulf Countries which continues to appear immune from the recent global pressures and some select bourses, such as Jamaica, Ukraine Taiwan (possibly for insulated reasons this week), and some others, it is broadly a sea of blood out there for last week.

Warren Buffett on Bond Insurers: Watching fires Burn Across The River

``The battlefield is a scene of constant chaos. The winner will be the one who controls that chaos, both his own and the enemies.” -- Napoleon Bonaparte

While in the past a misread on the reaction of local investors evoked a sense of panic on my part early August (discussed last week), most of what I have written then is coming into pass this time around.

In other words, this is sheer evidence of how attempting to “time markets” over the short term is almost an impossible task. Investing in the financial markets using ticker based assessments usually results to disastrous outcomes especially at critical turns and mostly when trading and or investing disciplines and money management are sacrificed at the altar of momentum or emotionally driven impulses. The previous pressure of “missing rallies” has now morphed into fear today for many market participants.

Again the formula of perceptive observation applied to judicious risk analysis combined with enduring patience and strict adherence to one’s investing discipline equals outsized returns through minimized risks. This can be epitomized by the latest activities of the world’s best stockmarket investor, the sage of Omaha, Mr. Warren Buffett.

In 2003, Warren Buffett vehemently argued against the use of derivatives, labeling it as a “Financial Weapon of Mass Destruction” (bbc.co.uk). This was publicly debated by with former Fed Chief Alan Greenspan (Forbes: The Great Derivatives Smackdown) and other financial experts and market participants who dismissed Mr. Buffett’s admonitions.

Four and a half years later, derivatives have been a key contributor in today’s financial turmoil and could likely be the epicenter of the next wave of leverage implosion via credit derivatives known as Credit Default Swaps or among counterparties in many suspect derivatives contract-known as Counterparty risks.

The Notional amount or Over-The-Counter Derivative contracts have grown to an astounding $516 trillion as of June 2007 (bis.org), with Credit derivatives expected to grow to some $33 trillion (bba.org.uk) or according to some estimates at $45 trillion (Forbes).

And for Mr. Buffett, a field littered with casualties from failed derivative gambits as seen in the Bond Insurance industry covering mainstays as ACA Financial Guarantee, AMBAC Financial Group Inc, MBIA Inc., Radian Group and others (money.cnn.com), becomes a timely opportunity for his entry, through his flagship Berkshire Hathaway, into the severely battered industry (ft.com).

Mr. Buffett appears to practice an age old Chinese proverb which deals with the warfare stratagem of “Watch the fire burning across the river”. The enemy dealing maneuver is part of the 36 collection of stratagems which advocates ``delay [in] entering the field of battle until all the other players have become exhausted fighting amongst themselves. Then go in full strength and pick up the pieces (wikipedia.org).”

With the industry mainstays running themselves aground through imprudent speculations, and neglectful evaluations of risks, Berkshire Hathaway is in the process of cornering the industry business from the fallen warriors.

So who among us can painstakingly wait for four-and-a-half years to seize an opportunity? Such is the redoubtable virtues Mr. Buffett seem to be preaching to us.

Selling Reaches Extreme Levels, Potential Bounce Soon?

That said, today’s selling pressures could likely be distinct from that in July-August of last year.

Our feedback is that some of the expectations seem geared towards the impression that the markets could deliver a similar reaction relative to last year. Hence, the assumption that today’s market ruckus is merely a short-term blip. Hopefully they are right. But for us, last year’s initial tremors seem to be more like a practice drill for today’s more earthshaking market action over the next months.

In July 2007, the violent gyrations in the global equity markets had been principally in response to the sudden seizure of credit access in US-Europe financial system. Following a rapid gamut of actions from global central banks, such tightness appears to have eased considerably since (Reuters).

Nonetheless, the distinguishing aspect from then is that markets appear to be pricing in an intense global slowdown possibly via the snowballing expectations of a US Recession…TODAY! Yes, that is according to Merrill Lynch, Goldman Sachs (telegraph) and others.

The sharp decline in commodities, equity markets and 40% collapse of the Baltic Dry Index, against a backdrop of a fierce rally US Treasuries (sharply falling yields), surging Japanese Yen (unwinding carry trades) and bottoming out of the US dollar Index have chimed in to emit a unified message.

True enough, brutal selloffs similar to last week may result to a sharp rebound as technical and sentiment indicators seem to have touched extreme levels, see Figure 2.

Figure 2: US Global Investors: Negative Two Standard Deviations

Mr. Frank Holmes of US Global Investors suggests that these areas of extremes are measured by a statistical tool called Standard deviations (SD) or a measure of statistical dispersion, which assess the spread of values in a data set. If many points in the data set are close to the mean then the SD is small, while if many points are far from the mean then the SD is large, whereas if all the data are equal then SD is zero (wikipedia.org).

According to Frank Holmes of US Global Investors (highlight ours): ``Over the past 60 trading days, the S&P 500 has dropped 14 percent. A decline of this magnitude last occurred about five years ago. As can be seen on the chart above [left pane-BT], this correction is approaching the same magnitude of other gut-wrenching events such as the collapse of Long Term Capital Management in 1998; Sept. 11, 2001; and the collapse of the technology bubble and the bear market that ensued in 2002.

Such high rarely occurring SDs, can also be seen in the histogram graph at the right pane, notes Mr. Holmes, ``The 60-day change on the S&P 500 has now fallen 2.18 standard deviations from the mean. There are very few periods with worse 60-day returns. In other words, odds favor a rebound from these levels.”

Why? Mr. Holmes adds, ``When markets fall for an extended period, or just have very sharp short-term corrections, fear begins to creep into investors’ psyches, and they begin to make irrational decisions. This becomes an opportunity for the investor who understands history and the math behind the market. These charts help us quantify the magnitude of the markets’ ups and downs and help us make better risk-adjusted decisions (emphasis mine).”

Given the technical oversold levels and the accelerating “fear” factor in the investing community, such extremes levels could trigger a ferocious short covering aside from potential short-term insurrection from the bulls.

But underlying question is will any forthcoming rally last?

Secular or Cyclical Trends, US Markets as Drivers and Opportunity Windows

The important thing to understand today is that since the market actions in the Phisix is STILL TIED to, or remains “COUPLED” to the activities in the US, the fate of the US markets remains of considerable influence to our forward direction over the interim. Hence the analysis of US markets, economy and forward policies are paramount.

Second is to identify and understand whether today’s declining phase comes out of a REVERSAL of the long term trend or simply a COUNTERCYCLICAL action, as we discussed in our October 23 to 27, 2006 edition, [see Should You Invest in the Phisix Today?].

If markets reveal that the secular trend has changed then necessary MAJOR actions need to be taken in one’s portfolio to adjust to the new conditions.

However, if markets merely suggests of transitional cyclical phases of mean reversion, or in the observation of legendary trader Jesse Livermore’s axiom, NO TREND goes in a STRAIGHT LINE, then it is normal to expect interim trends, such as a cyclical bear market phase amidst a secular bull market and vice versa, where slight portfolio adjustments could be made relative to one’s risk profile.

To consider, if sentiment reasons has purely weighed on the Philippine markets relative to a fundamental impacted credit-impaired US markets, essentially given Warren Buffett’s dictum where we have to be “greedy when everybody is fearful and fearful when everybody is greedy” then present opportunities poses as selective buying windows especially as prices are marked even lower out of plain investor psyche-fear. Yes, be reminded that ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised,” which is again another quote from Warren Buffett.

If it took the prescient Mr. Buffett more than 4 years to be proven right (again and again) with respect to derivatives (previously to the tech boom), then isn’t he now taking advantage of someone else’s or a majority’s folly or the present crisis as an opportunity to profit from? Why then fall for momentum or the bandwagon effect-which is after all another important psychological factor for underpinning today’s crash?

Again all these depends on one’s time frame and risks expectations; where participants has to reckon whether they are in the market for the punt or for momentum trades or for long term investing.

Measuring the Bad News

And since the US markets continue to serve as the world’s inspirational leader, persisting pressures emanating from the knock on effects of the imploding leverages within its financial system are taking its toll on global equity markets.

The contagion effect has been far reaching, from mortgages backed securities to Asset backed securities to Credit Debt Obligations and now to Bond Insurers, Credit default swaps on commercial property sector…as shown in Figure 3.

Figure 3: Danske Bank: More Bad News

The business of bond insurers is to underwrite insurance policies of bond issuers relative to missed payments or defaults. In the past, monolines (sole business is bond insurance) covered mostly municipal bonds. But the monumental bubble in the real estate sector induced a bandwagon effect of luring these insurers to expand its earnings by adopting complex risks models as mortgage backed securities and Credit Default Swaps in their portfolio.

The recent fallout from the collapsing mortgage backed securities have prompted a downgrade on several monoline insurers as MBIA, the largest bond insurer (wikipedia.org), which has lost about 85% of its share price (see topmost chart), as bond insurers are faced with huge payments on rising loan defaults. These companies have insufficient funding and/or capital to pay out on the insurance.

Further Chief Economist Steen Bocian of Danske Bank lists of the ramifications and other risks facing the US financial markets (emphasis ours), ``Bond insurers represent one of the systemic risks that have been a “ticking bomb” under the financial system. If the bond insurers get downgraded, their insurance will obviously lose value and the bonds they have insured will also likely be downgraded. This can trigger forced selling from investors that are holding the insured bonds if they are only allowed to invest in bonds with a high rating.

``Another risk at the moment comes from the commercial property sector. The activity in this sector has held up well but may start to be hit by the credit crisis and thus add to the woes in the construction sector. The Fed’s Beige Book reported that “reports on commercial real estate activity varied, with some reports noting signs of softening demand”.

Such far reaching contagion, which in essence signifies the question of the solvency of the US banking system, brings us to our earlier premise that global markets appear to be pricing in a recession scenario for the US economy.

Figure 3 from Northern Trust shows as how the S & P 500 performed from PEAK to TROUGH prior to and during a recession.

Figure 3 Northern Trust: The S&P 500 and Economic Recessions

Ms. Asha Bangalore of Northern Trust underscores two conclusions from the above, (highlight mine),

``(1). The S&P 500 is a leading indicator par excellence. Since the 1950s, the S&P 500 has always peaked before the peak of a business cycle, with one exception (1980 business cycle). The S&P 500 establishes a trough prior to the end of a recession without exception.

`` (2). The median percent decline of the S&P 500 from its peak to trough is 16.9%. In the first three business days of 2008, the S&P 500 is down nearly 7.0% from its peak in October 2007. If history is a guide, brace yourselves for a rough ride in the months ahead.”

From its peak in October 9 of 2007, the S & P 500 is about 15% down (Friday close) which is nearly within the median loss and 4% short of the average loss during the past cycles.

This isn’t to imply that we have reached the bottom; such would assume the average or median as the base. What we can say is that the path of least resistance is DOWN for the time being.

And that if a recession is truly underway or we are close to it, depending on the extent of impact on the economy- the degree or depth-and the response to the attendant policies aside from the duration-losses can go as high as 40% (1973-74) or 30% (2000-2001).

One must remember the meat of the losses occur during the transition towards a recession, as John Hussman wrote (emphasis ours), ``A large portion of bear market losses occur while investors are still denying the probability of a recession. By the time that a recession is well-recognized, significant damage has already been inflicted.

From which Mr. Hussman delivers a difficult poignant and pragmatic advice for the average market participant (highlight ours), `` For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy. It's likely that most investors who “caught” the rally in the stock market earlier this year never got out, because the features that would have prompted them to reduce risk (overvaluation, overbought conditions, overbullish sentiment) were the same conditions that would have prevented them from taking risk in the first place.”

Accepting Risk That We Can Retain

So what to do?

Again under the present circumstances, the degree of decline in the US markets aside from the behavior of other asset classes appear to indicate that the US could be in a recession, where using historical performance could lead to more losses if not a prolonged period of rough sailing ahead.

The impact of the present adjustments will depend on the how the US economy and markets responds to the policies adopted by the US government in reaction to the present deteriorating circumstances.

President Bush recently pushed for a $145 billion plan as safety net, alongside Bernanke’s recent avowed support for fiscal stimulus, which could complement central bank actions. So far the markets seem to have discounted these and continue to stagger. According to Calculated Risk, market expectations are priced in for a 75 basis points cut with the odds of 100 basis points of implied probability rising further. This implies that the financial markets expect more aggressiveness in policy actions. Question is: will authorities oblige?

The path towards expansionary policies in the US and elsewhere will have different impacts to different asset classes and should be evident soon (maybe as new measures are implemented), but for the moment markets will remain synchronized as the focus remains on the potential bandwith of the credit-securitization-derivatives induced losses and its repercussions to the broader financial system and the economy.

If global markets have been driven by sentiments than of fundamentals, the likelihood is that “decoupling” will probably reappear in the form of earlier recovery than outright dissociation.

Because extreme situations suggest of a near occurrence of a countertrend (meaning a bounce soon), it would be reasonable to adjust portfolios according to one’s risk profile under a defensive stance. To paraphrase Mr. Hussman, to accept risk…that we can be reasonably expect to retain.