Risk Reward Tradeoffs And Not Plain Vanilla Averaging Down Is What Matters.

``If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

A friend recently asked me if averaging down is the best way to approach the market, given today’s environment.

My response is- it depends.

In the investing sphere there is NO straightforward answer to glory, as much as there is NO Holy Grail or FOOLPROOF mathematical Greek “quant” formula or models to success.

For us, the success of such approach will depend on the market cycle, or it could also depend on the fundamental reasons behind the deterioration of the market or security or it could reflect on the discipline of the market practitioner.

Averaging Down = Playing with Falling Knives

Remember the basic rule is that PRICES ARE ALWAYS RELATIVE. Higher prices can become more expensive in as much as lower can prices can get cheaper.

The assumption that ALL prices that goes down will automatically always turn up is very dangerous. You may end up deeply hurting yourself by playing with falling knifes.

Table 1: Returns Required To Break Even

Table 1, as previously shown at our August 2007 article Why Cutting Losses Is Better Than Depending On Hope, depicts of the amount of losses and the corresponding gains required to offset or neutralize each losses.

The bottom line is that it takes MORE EFFORTS in the form of corresponding gains to offset every equivalent amount of loss initially generated. Imagine a 25% loss requires 33% gain to offset the original position as much as it would take a bigger 100% advance to cover up a former 50% loss. The bigger the loss, the greater the gains required to recover.

Therefore the assumption of “averaging down” means piling on more losses in the expectations that you can reduce your costs in the hope that the assets you’ve invested on would eventually recover. But what if it doesn’t? What if these assets continue to fall?

In essence, the basic problem with this assumption is that you don’t know WHEN the market/security stops falling. And if we keep adding to these losses, even if it does lower your averages, it exposes you to even more losses!

Figure 4: bigcharts.com: Averaging in Nasdaq’s Dotcom Bust Is Equivalent to Catching a Falling Knife

Market Cycles, Reference Points and Framing

Look at figure 4 courtesy of bigcharts.com. It is the chart from the US major technology weighted bellwether, the Nasdaq. If you had bought the Index in 1987 (leftmost red arrow) and held on it until today you’d still be up about 5 times even after the bust. But if you had “averaged down” consistently-periodically (say once every year on every market dips-assuming optimistically- but unrealistically- that you can catch every dips) you could have either given up some of these gains because of the sharp volatility swings during the latter half of the 90s until 2003.

But if you initiated buying anywhere near the peak of the dot.com bust in 1999-2000 and averaged during the past years (assuming equal level of the amount of purchase-with periodical averaging), you are still likely to be underwater (negative) even after eight LONG years!

And worst, if you bought into some of the favorite issues (and averaged “down” them!) during the heyday of the dotcom boom like Pets.com, Webvan, Exodus communication, Egghead.com, eToys or Furniture.com (cnn.com), you would have ended up with a big fat egg as these companies went kaput or bankrupt!

Remember, reference point always matters. Again if you initiated entry at the bottom of 2003 at the time when everybody was in disgust with technology issues then you are likely to be making some money today even if you periodically applied averaged “up” over the past few years. See the change in perspective? If I use the 1987 and 2003 as my reference point, you are most likely to be up, while if I utilize 1999-2000 perspective you are most likely down.

Don’t forget we are talking of nominal returns and not real (or inflation adjusted) returns. If we apply real returns on portfolio performance then your gains would be trimmed and your losses are likely to be accentuated (pls refer to table 1).

In essence, up or down (portfolio performance) depends on the date of entry, or prominently, on the whereabouts of the market cycle.

So we have to be wary of the nature of the “framing” presented to us by financial experts. From the hindsight everything is fait accompli, but what matters is not the past but the returns from taking on risk from the future. We can only learn from the past and apply its lessons in the future.

In addition, we can easily be captivated by the returns offered without understanding the risks behind such dynamics, this signifies as a basic caveat.

Risk Analysis Is A Fundamental Concern

In the same context, earlier this year, somebody suggested buying into US Financials as they believed that the string of sharp losses translated into feasible buying opportunities. We dissented, see Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

For us the US financials represents an epitome of a market trend that is in a structural decline.

Why? Because it will simply take years for US financials to normalize by writing off losses or by attaining full recapitalization following the gargantuan yet-to-be-revealed losses on their balance sheets, which is estimated to now reach $1.6 trillion by Bridgewater Associates (New York Times), after accrued recognized losses accounted for only about $400 billion or about 25% of estimates. Such losses may even adjust to the upside as the extent of damages becomes more visible.

In addition, financials will remain under tight pressure as it is in the process of “deleveraging” in the face of a “perfect storm”- tightening credit standards, falling economic growth, declining corporate profits, higher default rates, potential spread of asset portfolio losses (prime and Alt-A loan portfolios, commercial real estate, corporate and junk bonds) and high energy or consumer goods inflation.

Now add to the burden of the financials is the surfacing of the issue where a supposed implementation of a new regulation (FAS 140) that would lead to a prospective technical insolvency stirred a panic over “Government Sponsored Enterprises” or GSEs in Fannie Mae (FNA) and Freddie Mac (FRE), which paid for record yields on the sale of 2 year notes, saw a remarkable plunge in their stock prices see figure 5 and the attendant volatility in the US markets led by the financials.

Figure 5: stock charts.com: Trouble at the GSEs

Figure 5 courtesy of stockcharts.com, shows Fannie Mae and Freddie Mac (F&F) having been caught in a panic frenzy while S&P 500 Financials Sector Index (lowest pane) and S&P Bank Index (pane below main window) have altogether been in a sharp retreat since May.

For starters, Fannie Mae and Freddie Mac are privately owned companies but receive support from the Federal Government. Because of this privilege they also assume of some public responsibilities.

F&F are accounted for as among the largest corporations in the world. They function to provide for a secondary market in home mortgages by purchasing mortgages from the lenders who originate them. They also hold some of these mortgages while others are securitized and sold to other investors in the form of securities stamped with the GSE guarantee (Jack Guttentag-mtgprofessor.com).

Figure 6: NYT: GSE’s Reach of Problems

The recent GSE’s problem is a systemic issue.

According to RGE spotlights (Hat tip: Craig McCarty) ``F&F own or guarantee some $4.5 trillion or 45% of all outstanding mortgages in U.S. Much of the $1.6 trillion agency debt is held by foreign central banks, i.e. sharp reduction in 2004-2006 of agency debt due to accounting restatements contributed to 'bond yield conundrum' as foreign central banks had to resort to existing Treasuries in order to compensate for agency debt shortfall.” (highlight mine)

Aside, (see figure 6) these companies provide the capital that banks use to write new loans. If F$F stop buying loans, banks may stop making new loans, freezing the US housing market (NYT). In addition virtually every Wall Street bank and many overseas financial institution, central banks and investors do business with F&F (NYT).

Another, F&F acts as major counterparties in the interest rate swap market which hedges on prepayment risks and maturity mismatches on the balance sheets (RGE spotlights-Hat tip: Craig McCarty). The role of GSEs has heightened the concentration risks for these markets.

As you can see the GSEs are heavily imbedded into the world financials institutions such that in the event of a failure or default they are likely to generate total cataclysm in the world markets, which is not likely to be the case since regulators will likely intervene.

But the other side of the coin is that taxpayers will likely pay a heavy price over these rescue efforts, notes the astute David Kotok of Cumberland Advisors, ``The government backing of F&F is “implied” and not explicit. A Congressional guarantee would change that. Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.”

And this is the probable reason why the US dollar index got slammed (down 1.07%) and gold soared by nearly 3%. And this too is the principal reason why we can’t be fundamentally bullish on the US dollar (yet), because even while global governments will act to “superficially” contain consumer goods inflation by increasing policy inflation (government spending-subsidies or doleouts or via tariffs) the extent of damage in the US financial system is so huge that would translate to constant intervention from authorities (which means more inflation).

This brings us back to WHY “averaging down” isn’t always a good option, take it from David Kotok (highlight ours), ``Common shares of F&F are another matter. We value them at near zero. In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties. We believe the same is true for F&F. The stock market thinks so, too. That is why the equity value of F&F has been decimated. We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks.”

If a stock is going to zero, what good is it then to average down?

In terms of fundamental risk analysis, owning the aforementioned shares simply because it is going down or for averaging purposes is a recipe for the total annihilation of one’s capital. It can also signify a “value trap” or prices have gone substantially below fundamentals as to draw in value investors into believing they are buying value but then experiences further dramatic decline in value.

In this case, averaging down becomes the terrifying equivalent of catching a falling knife.

If we are insistent to use “averaging” on a bear market as a strategy then extensive risk analysis on the company or the industry’s risk reward potentials should be utilized. Otherwise we must remember the 2 general rules of bear market investing: one bear markets tend to get oversold and remain oversold and two, bear markets decline on a ladder of hope where support levels exist to repeatedly get breached until hope vanishes.

Averaging Down Is A Market Discipline

Finally, averaging down is an approach that should reflect the investor’s market discipline. A risk strategy utilizing this methodology means consistency in its application throughout the market cycles. It means rigorously knowing your risk appetite and the constant assessment of fundamental variables.

We cannot be a fundamentalist when the market is down and transform into momentum traders when the market goes up, for this only heightens your risks engagements- as you put more risk capital as markets go down-while limiting your profit potentials when the market goes up. Thus the risk reward tradeoff is tilted to the side of risks. Besides, only brokers get rich with such market attitude.

As world’s most successful stock market investor Warren Buffett once said, ``Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

The Socionomics of the First Philippine Olympic Gold Medal-Thank You Manny Pacquiao

``Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government.”-Milton Friedman (1912 –2006), an American Nobel Laureate economist and public intellectual

The Olympic season is upon us.

What more is there than to speculate on whether the Philippines will attain or harvest its first ever dream gold medal. And I believe that the time is ripe where boxing among other sports will most likely deliver the goods. And mind you, we may be speaking of more than just one medal.

Although I had been an aficionado during the era of Muhammad Ali and Sugar Ray Leonard, I haven’t followed the sport enough to know the chain of events since. Candidly speaking, not even much of the recent string of triumphs by our legendary Manny Pacquiao (until this article) or of the composition of our national team for the August Beijing 2008 Games.

The online Wikipedia encyclopedia says that the Filipinos have had a disappointing record of only 5 medalists throughout the years: 2 silver-Anthony Villanueva, Featherweight in 1964 Tokyo and Mansueto Velasco, Light Flyweight in 1996 Atlanta and 3 bonzes:-José Villanueva - Bantamweight 1932 Los Angeles, Leopoldo Serantes - Light Flyweight 1988 Seoul, Roel Velasco - Light Flyweight 1992 Barcelona.

These despite some 30 world professional boxing champions past and present; the noble list of Philippine boxing greats from boxrec.com -Pedro Adigue Jr., Rene Barrientos, Bobby Berna, Rolando Bohol, Frank Cedeno, Eric Chavez, Florante Condes, Roberto Cruz, Nonito Donaire, Morris East, Flash Elorde, Luisito Espinosa, Joma Gamboa, Ceferino Garcia, Eric Jamili, Tacy Macalos, Manny Melchor, Small Montana, Rolando Navarrete, Donnie Nietes, Manny Pacquiao, Rolando Pascua, Dodie Boy Penalosa, Gerry Penalosa, Erbito Salavarria, Jesus Salud, Malcolm Tunacao, Pancho Villa, Bernabe Villacampo and Ben Villaflor.

Of course one may argue that professional boxing and amateur boxing are worlds apart. This may somehow be true but overall the incentives from the expression of social mood could be an indicator of the sport’s likely bright future.

There are 3 main factors why I think the elusive Philippine Olympic gold medal in boxing will be within reach hopefully this August at the Beijing 2008 Games:

1. Social Acceptance

Prior to Manny Pacquiao’s glory, boxing as a sport has been mostly associated with the lower levels of the social strata. Pacman overhauled this image. Today, the proliferation of boxing gyms even within the rich enclaves (yes I have seen a gym at a hotel in Ortigas) have virtually closed the gap of societal participation in the sport.

This means that with more people-regardless of the income or social class-getting connected or involved, structural support (financing, training and etc.) for the sport is expected to mount.

2. Economics of Boxing and Wider Access to Financing.

Of course boxing is not only a sport, it has become an industry.

Aside from prestige or fame, Pacman’s humongous prize earnings, plus the ancillary fees such as pay per view, advertisement or sponsorships, merchandising, appearance and others (I suspect that these have even grown more than the prized earnings) should be another incentive to draw in more participants (players, trainers, coaches, investors, financers, media coverage etc.).

Of course Pacman signifies a statistical “fat tail”, whose feat will unlikely be replicated soon. The fact that he joins the ranks of Sugar Ray Leonard, Oscar de la Hoya, Roberto Duran and Floyd Mayweather Jr. in capturing championships in four weight divisions, the Pacman has become a legend in his own right and importantly one for the WORLD sports history books. What prestige!

The point is that the economics of boxing has shown its potential rewards in both tangible and intangible aspects as powerful incentives enough to attract a larger segment of participants. The Pacman model now becomes a sizeable magnet for the industry’s growth!

In contrast, in relative terms, Billiards, another sport where the Philippines have excelled internationally, has shown similar bandwith (of social acceptance and economics), but whose incentives (not included in the Olympics, lesser degree in terms of price money or fame or world audience relative to boxing) have not been as compelling enough to generate sustainability to the same level (as seen by the diminishing billiard pool outlets). Nevertheless, we are glad to see a continuing stream of supply of world billiard champions.

And this burgeoning economics of boxing has been emblematic with the sprouting of boxing gyms nationally. In short, the industry/sport now has not only garnered the social support but a wider reach or access to capitalization.

When finance greases the wheels of the industry/sport we expect a boom to follow with attendant results.

Importantly this also shows that private initiatives and not of government (in contrast to the conventional thinking) will drive the Philippines’ realization for world boxing supremacy-and our Olympic gold(s).

3. Plentiful Supply of Talents

As we earlier mentioned the Philippines has a cornucopia of boxing talents even during times when the sport was not as socially diffused as it is today. The 20+ champions (prior to Pacman regime) and 5 Olympic medals during those scarcity times are enough credentials to state of the endemic supply of champion quality boxers.

The snowballing economics fueled by social action will improve on the scale and quality of participation aside from increasing the pool of available highly qualified candidates for the championship class.

If I am not mistaken this marks the first time in Philippines sports history where we have four simultaneous incumbent world champions as of this writing, specifically Manny Pacquiao, Nonito Donaire Jr. IBF Flyweight, Gerry Penalosa WBO Bantamweight and Donnie Nietes WBO Minimumweight. This is a testament to the progressing dynamics from a booming boxing industry.

Of course in the games there will be other factors involved such as acclimatization, conditioning, the quality of opponents, judge biases and plain ol’ lady luck…among other variables.

The important thing to remember is that the greater the caliber or quality of our players emanating from the above dynamics, materially increases the odds for the realization of the long sought after gold medal/s. To my intuition, this dream could come into fruition by next month at the Beijing games.

To our Olympians (boxing and non boxing representatives), it's time to Go for Gold!

Has The Underperformance of Philippine Markets Been Due To Policy Credibility?

``In our opinion, global economic conditions are fraught with potential difficulties but Asia’s economic position puts the region in a strong position relative to the developed world. Budgetary and fiscal surpluses mean that countries have the scope to provide domestic stimulus. The banking sectors have ample liquidity and low non-performing loans; real estate prices are not in a bubble phase; corporate debt levels are low and after years of low investment there is not much excess capacity.” Edmund Harriss-Guinness Atkinson Funds, Asia Brief June 2008

So what else is new? The Philippine financial markets continue to get whacked. Again everything is being blamed on either high oil prices or “inflation” as if this whole episode is a restricted to a Philippine only affair.

Figure 1 from Dankse Bank shows the monthly returns of the Peso (left) and the Phisix (right)

Figure 1 from Denmark’s Danske Bank shows the Philippine Peso have been the worst hit among emerging market currencies (see red circle left), while the Philippine stock market benchmark has been the fifth worst performer among emerging markets (red circle right).

The Danske research team suggests that this has been all about central bank credibility. They for instance noted that Indonesia has far outperformed emerging market rubric in both currency (even gained last month) and stock market terms (the least losses) because investors perceived government actions as fitting to the present conditions.

From Danske (highlight mine) ``government has cut subsidies to avoid serious worsening of the fiscal situation and the central bank has moved fast to maintain its credibility. Indonesia has been rewarded by becoming the best currency in Asia, while India and the Philippines have been punished for dragging their feet on both fiscal and monetary policy.”

Indeed, pertinent to interest rates, Indonesia has ‘aggressively’ raised its benchmark rate for the third successive month (Bloomberg) compared to the Philippines which has reluctantly lifted only once (last June) for the first time in 3 years (Philippine Inquirer).

But for Indonesia to get “rewarded” for cutting subsidies where the Philippines has none is to assume the analogy of rewarding Indonesia for the transition from worst to bad when we are punished for maintaining the bad level. I don’t think this is the correct angle look at figure 2.

Figure 2 PIMCO: Real Policy Rates Are Negative in Emerging Markets

If negative real policy rates extrapolate as the fuel to the inflation fire, then certainly Singapore’s Central Bank should be interpreted as a paradigm or representative of the “bad policymaking” for having the steepest negative rate environment and should have been correspondingly meted with a market “penalty”. Likewise, Thailand, whose monetary regime has been similar to the Philippines, should also feel the heat. But where?

So if the conduct of policy doesn’t reflect the issue of real rates, then it can’t be about subsidies too. Look at figure 3 from the IMF.

Figure 3: IMF study: Change in Fuel Price Subsidies as a percent of GDP: 2006 to 2008

In IMF’s recent study “Food and Fuel Prices—Recent Developments, Macroeconomic Impact, and Policy Responses” it notes, ``Thirty-eight countries increased or decreased fuel price subsidies between 2006 and 2008. The increases (in 29 countries) range from near zero to 4.0 percent of GDP, with a median increase of 0.7 percent. The biggest increases have occurred in countries with large pre-existing subsidies. The decreases (in 9 countries) range from 0.2 to 5.3 percent of GDP, with a median of 0.6 percent, with the largest decreases in countries that were restructuring their subsidy programs.”

If the market’s “reward or punishment” system stems from policies of either subsidy reduction or subsidy gains, then those bars on the left (reduction) should see their currencies and stock markets outperform relative to those on the right (increases). Unfortunately the markets apparently don’t reflect on this line of thought.

Now of course currencies are valued based on relative terms. Or if we apply policy as a measure in valuing national assets classes then we have to parse on the obverse side-particularly policies governing the US dollar.

With 36 states in the US facing a decline (recession) as of May see figure 4, government’s fiscal positions risk getting slammed from declining revenues or tax collection in the face of rising government expenditures.

Figure 4: Nelson A. Rockefeller Institute of Government: 36 States on Decline

This from the Nelson A. Rockefeller Institute, ``The national economic slowdown—or recession —is depressing state tax revenue and restraining local government tax revenue. To date, the tax revenue weakness has been mild compared with past recessions. However, the seeds of greater fiscal stress are already sown: economic weakness is spreading rapidly and tax revenue from the “continuing” base should be very weak in the April-June quarter, although perhaps partially masked by payments with 2007 tax returns. After June, tax revenue is likely to be extremely weak as most states begin their fiscal years — and such weakness may linger as the year progresses. Many states finalized their 2008-09 budgets during the April-June quarter, when conditions may have misled forecasters into revenue projections that were too rosy. Governors in some states may, then, face difficulty implementing their new budgets —raising the prospect of midyear cuts and other actions to eliminate emerging gaps.” (emphasis mine)

What this suggests is that fiscal conditions in the US are likely to worsen. It would have to address this by painstakingly cutting expenses or inflating its way to cover such budget gaps or increase borrowing by issuing more debt instruments from foreigners or raise taxes. Whatever route taken is unlikely to be “positive” based on relative fiscal positions when compared to the Philippines.

All this go to show that while policymaking direction could be a factor influencing the market’s action, it certainly doesn’t show up in straightforward linkage.

However, we do share the frustrations over the Bangko Sentral ng Pilipinas’ dilly-dallying. In addition, we get even more concerned when we hear of our officials proposing to borrow money-$900 million from World Bank and ADB (Bloomberg)-in order to intervene in the currency markets to shore up the Philippine peso. This is like throwing money to a sinkhole, whose unnecessary losses will be charged to the taxpayers.

It would be a better option for the BSP to raise interest rates and reduce the negative real rates environment if they aim to defend the Peso and contain the consumer goods and services inflation pressures. But if the BSP is concerned about the impact to economic growth from higher interest rates, the market is doing it anyway for them through higher yields in domestic treasuries and from rising consumer prices. By closing the real rates gap at least they can’t be held solely responsible for “bad” policymaking. Besides, we read this labeling of bad policymaking as “reverse psychology”, maybe foreigners could be hoping for higher rates from the Peso to allow for them opportunities from a wider yield arbitrage.

Reverse Coupling, Inflation From The Core and Current Account Deficits

``Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

Finger pointing on policymaking is easy to do. Yet many analysts seem to forget that the global monetary regime functions under the US dollar standard system which runs on the fractional banking reserve system platform, whose underlying principle basically stems from leverage (reserves as a fraction of deposits).

Because the logistical agencies of the US monetary system have presently been undergoing severe deleveraging pressure, this has been spilling over into the real economy and equally reflected in the underlying asset prices which is likewise being felt worldwide see figure 5.

Figure 5: The Economist: Sinking Global Equity Markets

The Economist cites Standard & Poor’s estimates of the losses for the month June as having wiped out $3 trillion in global capitalization, mostly due to the horrific 10% losses in emerging markets.

And as we have been saying along-it’s all not about oil but a combination of factors from the softening economic growth, deteriorating profit outlook, rising interest rates and higher incidences of consumer goods inflation.

“Reverse Coupling”

Thus given these aggravating circumstances, the US Federal Reserves policies have been designed to keep interest rates at negative real levels considering the staggering amount of leverage built onto the financial system under the abovementioned environment.

And as we discussed last week in Global Financial Markets: US Sneezes, World Catches Cold!, this evidently could be the continuing policy thrust since authorities have in their radar screen the magnified view of heightened systemic deflationary risk. Apparently the central bank of central banks the Bank of International Settlements (BIS), have echoed the same risk and sees “inflation is a more immediate threat than deflation” (The Economist).

Hence, the Bernanke-Paulson tandem appear to be banking on a lower dollar and lever its economy through exports by turbocharging the economic growth to emerging markets via the transmission mechanism of US dollar linked monetary regimes and the expansion of the current account deficit. Essentially lower US interest rates have been stimulating emerging markets.

This excerpt from the commentary of Fred Bergsten, director of the Peterson Institute for International Economics at the Financial Times appears to corroborate our view,

``The improved US trade performance of the past two years is due partly to the substantial, if lagged, restoration of the country’s price competitiveness as the dollar declined by a trade-weighted average of 25-30 per cent since early 2002, reversing most of its excessive run-up during the previous seven years that produced unsustainable current account deficits exceeding 6 per cent of GDP. Equally important, however, is the continued robust growth of the world economy. Every percentage point by which the rest of the world expands domestic demand faster than internal growth in the US produces gains of about $50bn (€32bn, £25bn) for the US external balance. Weighted by US exports, foreign growth exceeded US growth by about 2 percentage points in 2007 and will do so by an average of about 1.5 points this year and next as decoupling persists. Taken together, these currency and comparative growth factors have already improved the real US trade balance, and hence GDP, by almost $150bn since 2006, with gains of another $150bn or so likely through 2009. (The nominal US trade and current account deficits will not improve as much because of the sharp rise in the price of oil imports.)

``The Organisation for Economic Co-operation and Development’s new Economic Outlook projects that more than 80 per cent of all US growth in 2008-09 will derive from continued strengthening of its external position. Exports have been climbing at an annual rate of about 8 per cent, at least six times as fast as imports. Unless domestic demand takes an unexpected further fall in the quarters ahead, reverse coupling of the global economy will thus have prevented the US recession that was so widely predicted and feared.”

So what you have is the US trying to utilize emerging markets to cushion its economic decline hoping that the global inflationary process from emerging markets would keep the US-UK deflationary forces at bay. However, the unexpected repercussion of this exercise is the risk of emerging markets to overheat and exacerbate the “inflation” in commodity prices particularly of food and energy.

An example, if you think record levels of oil prices have climbed enough to “destroy demand” in emerging markets, it’s definitely not showing yet. Car sales in June remained robust in India (+8%) Brazil (+30%), Korea (+9.2%), New Zealand (+5.5%) and Australia (+1.4%).

Inflation From The Core

If markets have been reappraising financial assets through policy actions shouldn’t it be the US that needs to be penalized more for its influential grip over other economies?

Yes, if you ask Doug Noland in his Credit Bubble Bulletin (highilight), ``I find it rather incredible that U.S. and European policymakers are increasingly pointing blame and calling upon their emerging economy cohorts to aggressively combat inflation. With the U.S. today stuck with intractable $700bn Current Account Deficits and European Credit systems still churning out double-digit Credit growth, the Periphery is not the root cause of today’s escalating global inflationary pressures. The global Credit system has run amuck, a process that evolved from years of Credit and speculative excess generated by, and tolerated at, the Core. It is today unreasonable to expect the Chinese or Asians generally to bring their booming economies to their respective knees to fight global inflation anymore than we can expect the Fed to tighten the economic screws to the point of balancing our Current Account and punishing the destabilizing speculators.

``Today’s inflationary dynamics have been developing for decades. Only discipline and stability at the Core of the global financial system would have stemmed the strong inflationary bias of contemporary fiat “money” and Credit. But the Core was instead egregiously undisciplined and unstable, setting the stage for the type of runaway inflation we are now experiencing. The Core came to love and rationalize asset inflation and consumption. The Periphery was forced along for the ride and happy to oblige.”

Of course, to a lesser degree the US dollar linked monetary regimes in emerging markets should bear some of these responsibilities for tolerating the US policy induced global inflationary environment.

Emerging Market Turmoil: From Carry Trade To Current Account Deficits?

On the other hand, perhaps the turmoil in today’s marketplace exceptionally seen in some emerging markets could be as a result of the shifting focus of the markets as the distortions from the carry trade in the face of heightened risk aversion fades while the market prices on the state of current account balances as suggested by The Economist see figure 6.

Figure 6: Economist: Current Account Balances Reshaping Asset Pricing In Emerging Markets?

From the Economist, ``ACCORDING to economic textbooks, the currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. This will stimulate their exports and curb imports, thereby helping to slim the trade gaps…Increased concern about current-account deficits is also causing investors to discriminate much more between emerging markets. A popular argument in recent years has been that developing economies are less risky because, unlike a decade ago, they are no longer dependent on foreign capital. It is true that emerging economies are forecast to have a combined current-account surplus of more than $800 billion this year, but this is more than accounted for by China, Russia and the Gulf oil exporters. In fact over half of the 25 biggest emerging economies now have deficits. South Korea is running a deficit after a decade of surpluses. Brazil has also moved back into the red, despite record high prices for its commodity exports. Others such as India, South Africa and Turkey have had external deficits for many years.”

While some of the performances in emerging markets appear to affirm such theory, it hasn’t been linear. For instance, the Philippines have severely underperformed South Africa and Turkey both of which have had deficits even during the heydays of the markets.

The Philippines isn’t about to turn into a current account deficit yet though. Current account surplus is expected to narrow to $4.2 billion from $6.9 billion (Reuters) despite the expected broadening of the trade deficit to about $11 billion-highest in 9 years on higher fuel and rice imports and weaker exports. So the recent underperformance of the Philippine asset class does not tally will or could be fully explained by this theory.

Thus, if we read by the activities in the market, such expectations are likely to be wrong (we will turn steeply into a deficit) or the market is inaccurately priced (market is wrong).

For the Philippine setting my conjecture is that the recent bear market has been exacerbated by internecine politicking see Philippine Politics: The Nationalist Hysteria Over Energy Issues.

Phisix: Too Much of Horror Movies

``In the sky, there is no distinction of east and west; people create distinctions out of their own minds and then believe them to be true." – Buddha

Local investors have been spooked by either inflation figures or elevated oil prices or both. The Phisix lost another 3.94% over the week to increase its year to date losses of 34.58%. From the Phisix peak in October 2007, the present bear market has accrued losses of about 39%.

Despite the net foreign selling this week, which was mostly due to the special block sales of San Miguel shares, board transactions reveal of a marginal net foreign buying. Again the rather slightly bearish bias to neutral outlook by foreign participants indicates of the locals at the driver’s seat.

The recent activities suggest that local participants continues indiscriminately sell the market in the assumption that the apocalypse is around the corner. This is a peculiarity though; retail investors hardly seem to know how to absorb losses which makes us suspect the ongoing selling pressures could possibly come from redemptions from indirect participants (e.g. bank UITFs, or Index funds or mutual funds).

Well we have been arguing that inflationary environments does not equate to financial Armageddon, there are industries that have been seen to benefit from the present environment see figure 7.

Figure 7 PIMCO: Winners and Losers

Pimco’s Mark Kiesel says that their company remains weighted in certain sectors (highlight mine), ``The energy, materials and metals and mining sectors remain areas we continue to favor in our credit selection process. In the case of energy, fundamentals tend to improve as price levels rise because higher inflationary periods typically result in strong top-line revenue growth for energy companies where demand is relatively inelastic. The industrialization of the emerging markets has led to significantly stronger demand growth for energy and put pressure on already tight resource supplies. Not surprisingly, gross margins for energy companies have expanded over the past several years as revenue has grown faster than costs.”

Why? See figure 7 again courtesy of PIMCO…

Figure 8: PIMCO: Who Has Pricing Power?

So inelastic demand, commodity pricing pass through, revenues growing faster than rising costs makes the aforementioned industries attractive.

Why have the local participants been selling? Because they’ve watched too much of horror movies.

Merrill Lynch Turns Bullish on Philippines

Investment banking heavyweight Merrill Lynch recently took a contrarian position by turning bullish on the Philippines according to the Finance Asia.

Merrill increased weightings on the country following the improvements in the company’s composite valuations which makes the Philippines the third most attractive market following Australia and Taiwan.

While Merrill sees rising oil prices as a challenge, ``Merrill Lynch notes that its new country allocation however appears to be in flagrant contrast to how a fund manager should be positioned, if the conviction is oil prices will keep rising. However, the firm notes that the impact of oil prices on a market is different from the overall call on that market,” notes Rita Raagas De Ramos for Finance Asia.

Read the rest here.

Denmark First European Country to Fall Into A Technical Recession; Many To Possibly Follow

This from Reuters: ``Europe got a first taste of recession on Tuesday when Denmark, a country that fronted the housing boom of the past decade, said economic output had shrunk for two quarters in a row.”

Courtesy of Danske Bank

This from Steen Bocian of Danske Bank, ``GDP actually fell by 0.6% q/q, or -0.7% y/y. The numbers were down right across the board . investments, private consumption and public spending all declined relative to Q4 07. The only bright spot was exports, which were up 1.1%.”

Courtesy of Elliott Wave

Other looming candidates: Spain, Ireland, UK, Netherlands and Portugal-following a bursting housing bubble whose magnitude to quote Susan Walker of Elliott Wave ``The surprise is the United States, which, when compared to Europe, looks like the epitome of fiscal conservatism.”

Odd Article of the Day: Dogs Inherit Billions!

Leona Helmsley’s favorite dog Trouble gets $12 million, while an estate worth $5 to $8 billion will be bequeathed to the welfare of dogs! Read here for the complete article from the New York Times.

Darned lucky Dogs!

Food and Oil markets: Market Signals Don’t Give The Right Incentives?

Recently we read from a prominent economist who argued that the reason markets don’t work in saving resources is that “market signals don’t give the right incentives”.

Nonetheless our self righteous expert didn’t say why the market signals have been behaving this way, but cited food and oil as an example.

To quote segments of this timely and incisive article from the liberal New York Times (Keith Bradsher and Andrew Martin)-accounts for the aberrations in food market dynamics (all highlights mine)…

Agriculture Trade Left Behind
Courtesy of NYT

``When it comes to rice, India, Vietnam, China and 11 other countries have limited or banned exports. Fifteen countries, including Pakistan and Bolivia, have capped or halted wheat exports. More than a dozen have limited corn exports. Kazakhstan has restricted exports of sunflower seeds.

``The restrictions are making it harder for impoverished importing countries to afford the food they need. The export limits are forcing some of the most vulnerable people, those who rely on relief agencies, to go hungry.

``“It’s obvious that these export restrictions fuel the fire of price increases,” said Pascal Lamy, the director general of the World Trade Organization.

``And by increasing perceptions of shortages, the restrictions have led to hoarding around the world, by farmers, traders and consumers.

``“People are in a panic, so they are buying more and more — at least, those who have money are buying,” said Conching Vasquez, a 56-year-old rice vendor who sat one recent morning among piles of rice at her large stall in Los Baños, in the Philippines, the world’s largest rice importer. Her customers buy 8,000 pounds of rice a day, up from 5,500 pounds a year ago.

``The new restrictions are just an acute symptom of a chronic condition. Since 1980, even as trade in services and in manufactured goods has tripled, adjusting for inflation, trade in food has barely increased. Instead, for decades, food has been a convoluted tangle of restrictive rules, in the form of tariffs, quotas and subsidies.

``Now, with Australia’s farm sector crippled by drought and Argentina suffering a series of strikes and other disruptions, the world is increasingly dependent on a handful of countries like Thailand, Brazil, Canada and the United States that are still exporting large quantities of food.

So EXPORT RESTRICTIONS imposed by national governments is one major factor…

World Tariffs Courtesy of New York Times

``Powerful lobbies in affluent countries across the northern hemisphere, from Japan to Western Europe to the United States, have long protected farmers in ways factory workers in Detroit could only dream of.

``The Japanese protect their rice industry by making it nearly impossible for imported rice to compete. The European Union severely limits beef and poultry imports, and Poland goes further, barring soybean imports as well.

``Negotiators have been working for years to free trade in farm goods, but today’s crisis actually makes that more difficult for them. Food protests in places like Haiti and Indonesia that rely heavily on imported food have convinced many nations that it is more important than ever that they grow, and keep, the food their citizens need…

So IMPORT RESTRICTIONS again by national governments likewise contribute as another major obstacle….

``In some of the nations concerned about shortages now, past policies have discouraged farming. From Indonesia to West Africa to the Caribbean and Central America, poor countries have frequently cut farm assistance programs and lowered tariffs to balance budgets and avoid charging high prices to urban consumers. But they have found that their farmers cannot compete with imports from rich countries — imports that are heavily subsidized.

``As a result, steps that could have taken place decades ago, resulting in more food for the world today, were abandoned. These included changes like irrigation schemes and new crop varieties.

``“The subsidies given by developed countries to their farmers have led to lack of investment in agriculture in developing countries” in Africa and elsewhere, Mr. Nath said.

``To make matters worse, the World Bank and the International Monetary Fund frequently pressured poor countries in the 1980s and 1990s to lower tariffs and to cut farm support programs, mostly to reduce budget deficits.

``Indeed, the World Bank concluded in 2006 that not enough attention had been paid to the negative effects of its policy prescriptions on farmers in developing countries.

``The current export restrictions, which mainly help urban consumers in poor countries, are the latest blow to farmers in the developing world.

``Arfa Tantaway Mohamed, who grows rice on three-quarters of an acre outside the bustling town of Aga in northern Egypt, is frustrated at Egypt’s export ban, which is suppressing rice prices."

Third and Fourth factors include, VACILLATING POLICY PRESCRIPTIONS and SUBSIDIES…again by national governments.

One of IMF’s proposed solution (ironically a multilateral “government of governments” organization) is…

``Trade polices. Global food markets need to be kept open, with restrictive policies, such as export taxes and bans, removed to maintain appropriate incentives for producers and consumers. Tariff reductions can help to reduce trade distortions and mitigate price increases.”

So none of the above looks like a malfunction caused by market forces, instead they come from distortive government policies.

As for oil we excerpted this article from Jim Mctague of Barrons online,

``Drilling in the Gulf has long been contentious. On one side are the tourism, real-estate and environmental industries. On the other are those dastardly oil men, the J.R. Ewings that everyone loves to hate. Five years after the 1973 Arab oil embargo, Congress amended the Outer Continental Shelf Lands Act to give states, local governments and environmental groups more leeway to challenge drilling in federal waters off their coasts, and they did just that with the enthusiasm of terriers chasing rats.

``James Watt, President Ronald Reagan's environmentally hostile, politically inept interior secretary, tried to reverse the restrictive trend in 1981. He proposed opening almost the entire Outer Continental Shelf to drilling. Coastal communities howled like injured coyotes. California's congressional delegation slipped a provision into an appropriations bill that year that placed a moratorium on drilling off that state's shores. Subsequently, Congress enacted separate moratoriums for Florida, New Jersey, California and North Carolina.

``Those bans didn't cover the Destin Dome, which went on the block in 1984. Chevron and partners Conoco and Murphy Exploration & Production drilled three exploratory wells there in 1987, 1989 and 1995 that found an estimated 2.6 trillion cubic feet of natural gas. But to actually produce gas, Chevron needed federal and state approval.

``Chevron submitted a development plan to the state and the Interior Department for review in 1996 -- an inauspicious time for offshore drillers. George Bush I in 1990 had placed a temporary moratorium on new drilling off South Florida, fulfilling a campaign promise to Sunshine State voters. Then, in 1995, the Clinton administration came out against new lease sales, and Florida's congressional crew, both Republicans and Democrats, successfully supported another moratorium on new drilling to replace one that had expired.

``Chevron proposed drilling 12 to 21 gas wells. Florida bureaucrats took their sweet time before nixing the application two years later. Chevron appealed to the Department of Commerce, which can overturn state decisions. Reluctant to upset anyone, Commerce simply stalled. Under the law, there is no deadline on appeals. Chevron sued the federal government in 2000, claiming it had been denied a timely and fair review of its plans. Clinton stepped down, and Bush II was sworn in. His Commerce Department twiddled its thumbs, too. Meanwhile, Bush met secretly with Florida's then-governor -- his brother Jeb -- a foe of offshore drilling. They agreed to have the federal government buy back the leases for $115 million and place a moratorium on drilling at the Dome until 2011. There are now 140 actual leased tracts there that can't be drilled, reports Lisa Flavin, a senior policy adviser at the American Petroleum Institute in Washington.

``When President Bush suddenly flip-flopped this month and said he favored drilling on the Outer Continental shelf, Democrats accused him of wanting to give more land to Big Oil. Thundered Rep. Ed Markey of Massachusetts: "Oil companies already own 68 million acres of drillable land and sea, which is the size of Georgia and Illinois combined, but they're not producing there." They should use it or lose it, he added. But those acres include the Destin Dome!

`` Chevron took its lease refund to help finance a $12 billion project in Angola to produce liquefied natural gas for shipment here. Ironically, a major gas pipeline between Texas and Tampa runs right by the Destin Dome.

Again, populist and vacillating policies, regressive ideologies and environmental restrictions have kept supplies out of the market.

Overall, the problem of the inadequate diffusion of the incentives of market price signals basically stems from the mismatch between the incentives of LESS price sensitive economic agents who heavily regulates the supply side (government) and the price sensitive economic agents who accounts for the demand side (consumers).

Investments can’t happen when governments restrict them. Trade can’t happen when governments prohibit them. Prices surge when demand and supply imbalances are further aggravated by government hoarding! Thus, price signals don’t reflect efficient resource allocation because governments obscure them.

So it isn’t the problem of markets but one of government intervention.

Financial Globalization: PSE-NYSE Euronext ‘MOU Of Cooperation’ A Step Towards Future Integration?

In our January’s Unifying Global Stock Markets; Asia Looks Next!, we deduced (speculated) that Asia could the be next phase in the ongoing integration and consolidation of global capital markets.

Courtesy of Philippine Stock Exchange

Just recently the PSE and the NYSE Euronext signed a memorandum of understanding (MOU) for cooperation, to quote the PSE-

``To explore new opportunities in trading system architecture and technology, exchange traded products, market participant connectivity and market data management…

In addition, notes the PSE, ``The MOU also includes details on the PSE’s acquisition of a new trading system from NYSE Euronext and its affiliates, which was announced in April 2008. Under the terms of the NYX-PSE MOU signed today, areas of possible cooperation involve the sharing of information and experience on new stock markets products and services. The MOU also embodies the common goal of both companies to provide investors worldwide protection and operating fair, orderly and efficient markets. The MOU was drafted in the spirit that international cooperation between the two exchange companies will facilitate the development and efficient operation of all securities markets operated by the exchange groups.

So at a start what we could expect perhaps to see is the introduction of Exchange Traded Funds and (hopefully) expanded cross listings from listed companies at NYSE Euronext bourses.

Of course, the signing came with a photo-op as Philippine Stock Exchange officials rang the opening bell in one of the recent sessions in Wall Street. You can see the roster of officials at the PSE website.

Bottom line: once the infrastructure have been meshed (trading architecture), what’s to stop NYSE from reinforcing further “cooperation” by acquiring substantial stake at the PSE or a prospective merger and or acquisition.