BSP’s Actions Should Reflect Sound Money Policies, Philippine Banks Can Afford Tightening

``The whole policy . . . must be looked upon as a case of price-fixing by which the rate of interest . . . was kept artificially lower through an unsound use of government control over banking policy. The results were speculation, inflation of prices, and eventual disillusionment and loss to investors and to large numbers of other citizens.”-Frank A. Fetter Modern Economic Problems, The Century Company

For us, the BSP should continue to raise its policy rates even if the statistical inflation index diminishes in the near term.

Raising interest rates to positive real levels will relieve policymakers of the blame of unbecoming conduct and inducing an inflationary regime, aside from reducing imported inflationary pressures via currency appreciation.

Besides, we believe that the banking sector and the Philippine economy are resilient enough to withstand further tightening.

The pervasiveness of the informal economy stresses the point that LIQUIDITY is the more important variable, since informal financing has made the sector inured to high interest rates or “5-6” microlending schemes as discussed in Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation.

Next is ACCESS TO FINANCING. As testament to the low penetration level of the banking sector, according to BSP chief Amando Tetangco Jr., ``Rural banks alone cover around 80% of the total municipalities in the Philippines with nearly 730 banks and over 2,000 branches nationwide.”

But of course, with the composition of investment patterns that are likely to shift towards resource or commodity oriented industries in the rural areas, the growth of rural banks according to our BSP chief has been ``faring equally or even better than its universal, commercial and thrift bank counterparts while remaining true to its core mission of serving the needs of the countryside.” And this trend is likely to get better.

Another, mainstream bank financing growth has improved modestly but has been concentrated to mostly consumer lending. The Philippine Daily Inquirer quotes BSP Deputy Governor for bank supervision BSP Deputy Governor for bank supervision Nestor Espenilla Jr. ``Loans to the corporate sector haven’t been growing too much. What’s driving growth is consumer loan and basically this mirrors the vibrance of the consumer sector of the economy. This has something to do with the [overseas Filipino] remittance story,” he said."

In short, the expanded rural income will probably be helped by remittances and will continue to find financial intermediation support from the banking sector, most especially from the rural areas.

Finally, in consideration of overall bank intermediation, this statement from the IMF ``Despite substantial progress in reducing NPAs, they remain large and depress bank profits. Bank lending remains low, well below funds raised in the capital market in 2007, as banks are willing to lend to only their best clients. The credit reporting system is poor, only 5½ percent of adults are currently covered, and an inefficient bankruptcy code extends recovery time to 5¾ years and reduces recovery rates to 4¼ percent.”

In other words, bank lending remains highly conservative, given the shortcomings of credit reporting or bankruptcy code as the IMF cites which indicates need for administrative reforms.

Moreover, the anguish from the Asian Financial crisis probably remains impressed on our bankers, hence the functioning hindrance in the access to credit.

These are some other banking highlights from researchandmarkets.com, which suggests of the vitality of our banking sector (highlight ours)

- Deposit mobilization is concentrated with universal and commercial banks, which account for the majority of the Philippine banking industry deposit.

- Financial Intermediation was the largest shareholder of the loan disbursal by banks during 2004-2007.

- Bancassurance will account for 65% of the total sales of insurance products by 2011.

- Increasing at a CAGR of 69.78%, microfinancing in the Philippines is expected to reach 56.5 Billion Pesos.

- Increasing mobile penetration will expand the mobile banking user base to more than 11 Million by 2011.

With reference to the Philippine Stock Exchange, some suggested that increasing rates will reduce the public’s incentive to invest in the stock exchange.

This premise will probably hold true if local participants dominate the trading activities. The fact is that only a scant segment of the Philippine society of approximately 1% has invested in the PSE directly and indirectly, which means that foreigners are likely to remain as main navigators of the Phisix. And our guess is appreciating currencies, controlled “inflation”, and improving balance sheets are more of an attraction once the financial chaos in the system settles than simply rising interest rates.

Bottom line: Interest rates are not the only variable that will determine capital flows. The BSP can afford to raise rates by responsibly closing the gap of the real interest rates and at the same time addressing regulatory reform issues, while the Philippine banking system given the present economic conditions can afford to withstand such tightening measures.

Philippine Peso: Technical Pattern, BSP Actions and Diminished Inflation Points To A Rally

``In a free economy the principal cause of a cumulative deficit in a country's international payments is to be found in inflation . . . In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies.”- Michael A. Heilperin, International Monetary Economics

With the hazard from “food and fuel inflation” likely to diminish, there is a strong likelihood that the Peso could rally following its latest string of precipitate decline.

Figure 6: DBS Bank: Peso’s habitual 45-47% retracements

Of course, the BSP’s unexpected 50 basis points hike provoked a furious rally in the Philippine Peso up 2.45% over the week.

But nonetheless we would like to emphasize that a rallying Peso might not reflect equal strength into other the Philippine asset classes YET, unless foreign sentiment reverses.

I have seen similar patterns abroad with currency strongly firming up, such as some CEE (Central and Eastern Europe) nations or Norway, as central banks raise rates to positive levels but equity markets continue to falter.

Most of the weaknesses in these financial markets (including the Philippines) could be traced to decelerating global economic growth and the ongoing international credit crisis than from “inflation” (which has admittedly aggravated the circumstances than have caused it).

However, I maintain the view that perhaps we are in the 8^th to the 9^th inning of the cyclical decline or nearing the bottoming phase for the Phisix, barring any major shocks.

Stripping away the fundamental argument, DBS bank believes that the Peso has a habit of correcting 45%-47% before resuming on its major trend.

Quoting DBS Bank, ``Historically, USD/PHP is known to retrace about 45% of large moves, like it did in 1997/98 and 2000/01. Like these two episodes, the PHP is currently confronting an uncertain global economy. Assuming that the same 45% retracement takes place, USD/PHP could extend its rise to 47 before entering into a broad consolidation, possibly between 41 and 47. If export competitiveness becomes a priority with the government, the consolidation range could be narrow at 45-47 instead.”

With amplified recession risks coming from a global economic growth slowdown, Anglo Saxon economies are likely to commit more of their taxpayer’s money into patching up the gaping holes into their respective financial markets which extrapolates to more balance sheet expansions or fiscal degradations (a.k.a. inflationary activities). So aside from the probability of reduced “domestic” inflation, compounded by the prospects of further BSP actions, a strengthening Peso could be in the offing.

As for market timing or the practice of financial astrology, we are most of time too early.

Globalization Highlights From Past To Present

The historical contribution of Globalization to world economy, from the Economist,

``GLOBALISATION, as historians of the subject like to point out, has been around for a long time. Industrialisation and technological changes—such as the invention of the steam ship, which produced cheaper means of migrating and trading between continents—spurred one period of globalisation in the 19th century. In similar fashion new inventions—jet aircraft, the internet—helped to encourage later periods of it. In a new World Trade Report published this week, the WTO compared three broad periods, looking at global growth in GDP, in population and in the trade of goods. Migration rates are shown only for four countries of the “New” world.

courtesy of the Economist

Present Trends as Indicated by the WTO 2008 World Trade Report

Accelerating world economic growth…

Rising Per Capita…

And broad based Poverty Alleviation…

This from WTO (highlight mine)…

“International trade is integral to the process of globalization. Over many years, governments in most countries have increasingly opened their economies to international trade, whether through the multilateral trading system, increased regional cooperation or as part of domestic reform programmes. Trade and globalization more generally have brought enormous benefits to many countries and citizens. Trade has allowed nations to benefit from specialization and economies to produce at a more efficient scale. It has raised productivity, supported the spread of knowledge and new technologies, and enriched the range of choices available to consumers. But deeper integration into the world economy has not always proved popular, nor have the benefits of trade and globalization necessarily reached all sections of society.”

Unfortunately globalization trends, despite its tremendous advantages, are highly unappreciated or unpopular simply because it is imperfect. But much of these has been borne out of the market distorting policies.

The message is the world needs more trade than relying too much from government.

Does The Violence In Pakistan’s Stock Market Signify Signs of Panic?

Some people have taken the recent stock market plunge to the political realm.

From Bloomberg (highlight mine), ``Pakistan's main stock exchange received police and paramilitary protection after investors stoned the building in protest at collapsing share values.

``I have lost my life savings in the last 15 days and no one in the government or regulators came to help us,'' said Imran Inayat, an investor who was part of the protest.

This is the common problem with retail participants: most of them don’t understand the risks involved in the financial markets. They jump in when market momentum keeps moving up (because mostly of the misleading notion of “keeping up with the Joneses” and the prospects of "perpetual short term gains") but when slammed with losses they demand regulators to “save them”.

In short, privatize profits but socialize losses from reckless activities.

Courtesy of Bloomberg: Pakistan’s Karachi 100

Seen from the long term, the returns for long term investors hasn't been all that bad; Pakistan’s Karachi 100 has been up by over 300% since 2004 and has lost nearly 35% from its peak.

It's just a matter of overconfidence turned into frustrations especially for retail punts.

In addition, government intervention only complicates the situation…

Again from Bloomberg,

``Regulators this week eased curbs on trading, removing a 1 percent limit on price declines that led trading volumes to fall to the lowest in a decade. Shares have slumped 29 percent this year, ending a rally that had pushed the key index more than 14- fold higher since 2001.

``There has been some level of mismanagement by the authorities,'' said Habib-ur-Rehman, who manages the equivalent of 6.5 billion rupees ($90 million) in Pakistani stocks and bonds at Atlas Asset Management Ltd. in Karachi. ``This may be due to their misperception that they can prevent the market from falling. Investors have to learn to bear losses as they do gains.''

You can watch the video from Javo.tv (hat tip: Charleston Voice)
...

...

The point is-in the psychological cycle of markets, this indicates of a transition to the cycle of desperation and panic which eventually culminates with capitulation or depression...or your market bottom.

Perhaps the Pakistanis are nearly there.

Sir John Templeton's Legacy: 8 Precious Investment Tips

John Christy of Forbes had been fortunate enough to get the last words of wisdom from our investing icon Sir John Templeton who just recently passed away last July 8. Rest In Peace, Sir John, you will be missed.

Anyway here is our departed guru’s legacy to the world as enumerated by Forbes Mr. Cristy (all green highlights mine)…

1. All investing is global. Templeton became famous in America for promoting the idea of global diversification, but he didn't invent the concept. After studying law as a Rhodes Scholar at Oxford, Templeton embarked on a whirlwind journey that took him to 35 countries in seven months. In his travels, Templeton simply noticed that there were far too many opportunities outside the U.S. to ignore. And that was back in the 1930s. To this day, academics and financial advisers use fancy equations and pie-charts to justify the case for international investing. For Templeton, it was always just common sense.

2. Always take a contrarian approach ... "People are always asking me where the outlook is good, but that's the wrong question," Templeton explained to Forbes in 1995. "The right question is: 'Where is the outlook most miserable?' " This is Templeton's famous "principle of maximum pessimism." It runs counter to almost every other big decision we make in life: choosing a company to work for, a neighborhood to live in or a person to marry. But that's what makes investing so difficult and the reward for successfully betting against the crowd so compelling.

3. ... But make sure the fundamentals are intact. Identifying out of fashion sectors or countries is merely a starting point. The corollary to the principle of maximum pessimism is that the underlying, long-run fundamentals must be sound. Pessimism once ran high at Bear Stearns, and for good reason.

4. Let valuation be your guide. Many "sophisticated" international investors insist on divvying up the world into a catalogue of developed, emerging and frontier markets, based on Morgan Stanley (nyse: MS - news - people ) Capital International's classification system. But Templeton had already made a killing in Japanese stocks in the 1960s before MSCI even existed. Was Japan developed or emerging back then? It didn't matter. Its stock market traded at four times earnings and the Japanese economy was growing like gangbusters.

5. Don't be afraid of big bets. At one point in the 1960s, Templeton held more than 60% of the Templeton Growth Fund's assets in Japan, an allocation that would get a manager fired on the spot at most mutual fund houses today. That's an extreme example, but investors shouldn't be afraid of bold bets whenever their research uncovers a big opportunity. Besides, Templeton wasn't a big fan of investment committees anyhow: "I am not aware of any mutual fund that was run by a committee that ever had a superior record, except accidentally."

6. Don't rush into positions. Templeton was an investor, not a trader. But even for patient investors, it can be frustrating to watch a cheap stock get even cheaper before the rest of the crowd catches on. Bottom fishers in financial stocks today know this all too well. In 1988, Templeton gave Forbes readers an important piece of advice that is especially relevant today: Always put your new investment ideas on a watch list, or take a small position before rushing in. If it's a truly great bargain, there's no need to hurry.

7. Get away from the crowd. "Outstanding performance cannot come from someone who is always part of the herd." While Templeton meant this in the sense of being a contrarian, he physically distanced himself, too. One of his early investment partnerships, Templeton, Dubbrow & Vance, was in the heart of Manhattan at Rockefeller Center, but Templeton spent the latter part of his career in the Bahamas, where he moved in the 1960s. Avoiding U.S. taxes was the big reason, but Templeton frequently cited the distance from Wall Street's noise as an advantage to his decision-making. And this was in the days before Bloomberg terminals, BlackBerrys and CNBC.

8. Don't worry about the direction of the market. In a 1978 Forbes cover story, Templeton summed it up this way: "I never ask if the market is going to go up or down because I don't know, and besides it doesn't matter. I search nation after nation for stocks, asking: 'Where is the one that is lowest-priced in relation to what I believe it is worth?' Forty years of experience have taught me you can make money without ever knowing which way the market is going."

The 13 Worst Email Scams To Avoid

Avoid falling for email based scams says Mr. Mark Nestmann, Privacy Expert & President of The Nestmann Group, in an article published at the Sovereign Society.

Each of the scam has a similar pattern. Mr. Nestmann advices, ``All these scams start with you sending them money. When you don't receive the promised funds, you'll be told "difficulties have arisen." To resolve the difficulties, you must send — you guessed it — more money.”

The Dirty 13 Scams…

1. Jackpot Scam. You've just won the jackpot or the lottery that you never entered, but to get your full winnings, you must first pay various fees.

2. Inheritance Scam. You've inherited a large sum of money from a mystery relative or some other person. To claim your inheritance, you must first pay taxes and fees.

3. Murdered Politician Scam. The widow or child of a dead politician in a third-world country contacts you for assistance. The politician stashed away a few million dollars in a foreign bank account, but the widow/child can't get to it without your help. You'll get a percentage of it if you help retrieve the funds, but first you must send money to a "lawyer."

4. Company Representative Scam. A foreign company wants your help to process payments from its customers. They want to use your bank account to process checks, money orders, credit card payments, etc. But first, you must pay a fee.

5. Government Contract Scam. Someone who has supposedly won a lucrative contract with a government in Africa contacts you for assistance. If you help him bribe the appropriate officials to finalize the contract, you'll receive a portion of the proceeds.

6. Dying Widow/Wealthy Merchant Scam. A wealthy widow or wealthy merchant has terminal cancer and wants your assistance in funding their favorite charity. You'll get a portion of the inheritance, but first, you must send money to a lawyer.

7. Rich Investor Scam. A wealthy investor wants to invest millions in your business. But first, you must send money to a lawyer to draw up a contract.

8. Loan Scam. You've been awarded a loan on very favorable terms, but first, you must send money to pay various fees or taxes.

9. Oversized Check Scam. A foreign person wants to buy merchandise you advertised on e-Bay or elsewhere, but mistakenly draws up a cashier's check for a larger amount. He asks you to wire the balance to a "shipping agent" before sending the payment.

10. Recover from a Scam Scam. The FBI, IRS, or other law enforcement agency contacts you by email and asks for your assistance in recovering money from advance fee fraudsters. First, however, you must send them money. (Law enforcement agencies never do this, but this doesn't stop scammers from impersonating them.)

11. Credit Card Scam. You've won a credit card with a million-dollar credit limit. But first, you have to pay a few thousand dollars as an "activation fee."

12. Job or Immigration Scam. You've just been awarded a lucrative employment contract or visa to an EU country. But first, you need to send money to a fake immigration official or lawyer.

13. Lonely Hearts Scam. A beautiful woman you meet online wants you to marry her. She wants to come visit you in the United States (or wherever you live). But first, you must send her money for an airline ticket.

Food Crisis: The Economist Suggests Eating “Bugs” To Solve World Hunger.

A proposed radical solution for world hunger and environmental preservation: Eat Bugs! (Yuck!)

This from Green.view of the Economist, ``The world is getting hungrier. After years of falling food prices, eating is suddenly getting expensive. With price-tags now rising some 75%, the World Bank estimates that the soaring cost of food will push 100m people into poverty. What with rising fertiliser prices, increasing concerns about deforestation and unreliable rains brought on by climate change, how will we find new sources of nourishment?

``Scientists at the National Autonomous University of Mexico have an answer: entomophagy, or dining on insects. They claim the practice is common in some 113 countries. Better yet, bugs provide more nutrients than beef or fish, gram for gram.

Courtesy of the Economist

``Meat provides just under one fifth of the energy and one third of the protein humans consume. But its production uses up a hugely disproportionate share of agricultural resources. Feed crops gobble up some 70% of agricultural land, while a quarter of the world’s land is devoted to grazing. Brazil’s burgeoning livestock industry is responsible for huge swathes of deforestation in the Amazon.

``As developing countries get richer meat’s ecological footprint is set to get even bigger. The Food and Agriculture Organisation (FAO) at the United Nations considers livestock “one of the top two or three most significant contributors to the most serious environmental problems, at every scale from local to global.” It predicts that the world’s demand for meat will nearly double by 2050.

``Eating insects does far less damage. For one thing, the habit could help to protect crops. Some 30 years ago the Thai government, struggling to contain a plague of locusts with pesticides, began encouraging its citizens to collect and eat the insects. Officials even distributed recipes for cooking them. Locusts were not commonly eaten at the time, but they have since become popular. Today some farmers plant corn just to attract them. Stir-frying other menaces could help reduce the use of pesticides.

Read the entire article here.

Phisix: Learning From the Lessons of Financial History

``Here’s the thing: When you get diversity breakdowns in markets, you get bubbles and crashes. When you get diversity breakdowns in societies, it’s ideologically similar. As Scott Page has shown, diversity (markets, ideas, ecologies) is a key to stability and growth.”-Josh Wolfe, Forbes Nanotech

In loving memory of my uncle Marciano U. Te (January 2, 1926-July 7, 2008)

``“The mistakes of a sanguine manager are far more to be dreaded than the theft of a dishonest manager," wrote Walter Bagehot. The best protection against excessively sanguine beliefs is the study of financial history, with its many examples of how easy it is to be plausible, but wrong, both as financial actors and as policy makers. Perhaps we need a required course in the recurring bubbles, busts, foibles and disasters of financial history for anyone to qualify as a government financial official. I have the same recommendation for management development in every financial firm.” Thus wrote veteran banker Alex Pollock, a resident fellow of the American Enterprise Institute, in advocating that the lessons from Financial History represents as the paramount guide into shaping of regulations-where history manifests of a slew of policy actions in reaction to market developments and their unintended backlashes-or for financial actors when divining portfolio strategies.

The most common problem we observe is that the public loves to adhere to simplified understanding of a complex problem, usually sourced from mainstream news, and apply nostrums as solutions. Whether it is the rice crisis, stratospheric oil or energy prices, or Phisix bear market it is basically all the same, we find a culprit, pin the blame on them without examining in depth why all these came about and worst, proffer solutions that are usually knee jerk responses bereft of historical morals which usually gets us mired into more trouble in the future.

Understanding the Phisix Bear Market

The Phisix, like most of the major equity benchmarks in the world including the US, is in a technical bear market, down by nearly 40% (37% to be exact based on Friday’s close). Since mainstream media is so fixated with oil and food, thus accordingly our market is likewise allegedly bogged by such issues.

We hardly hear any voice including from our so-called high profile experts in dealing with other pertinent issues: the continuing gridlock in the global credit market, the worsening economic slowdown in major developed worlds as a result of the deflating housing bubbles and attendant signs of contracting liquidity or monetary tightening in the global marketplace which has now become discriminate.

Of course, we do not share with depression advocates the view that the world is headed for Armageddon or that global financial “decoupling” is a fiction. As we mentioned, shrinking liquidity has made investment destinations become rather choosy or discriminate and our observation of Africa (see Recoupling and Inflation Doesn’t Explain Everything…) as benefiting from the present environment has been corroborated by the Economist magazine (emphasis ours),

``At the start of this year, some 15 sub-Saharan African countries had stockmarkets, listing some 500 companies with tradable shares and a combined market capitalisation–excluding relatively mighty South Africa's–of $100 billion, according to a report from Goldman Sachs, “Africa Rising”. Since then, these markets have mostly soared ever higher, even as shares everywhere else have plunged to earth. The best performing stockmarket among this impressive bunch is Ghana's, up by one-third so far this year.”

If this isn’t “decoupling” then I don’t know what this is suppose to represent.

Is it not a wonder why Africa seems immune to the same problem we or the world have been suffering from? Is it not the Philippines an “economically” better positioned compared to these states? So what’s the difference?

Honestly speaking, we don’t have an answer to everything although we do have some suspicions (prolonged years of underinvestment, prevailing commodity resource boom, probable portfolio rotations and China’s growing role in financing Africa’s infrastructure investments).

But there is one thing we can be sure of; if the premises cited by our financial experts do not seem to be applicable to African states, whom are supposedly in a far inferior position relative to us (based from the standpoint of economic statistics) or to most of our neighbors, then the likelihood is that the same conventional justifications used at our end stands from tenuous grounds.

Financial History And The Phases of Bear Markets

Figure 1: Phisix: History Shows 4 Bear Market Cycles

This brings us to financial history.

Financial markets are basically characterized by market trends borne out of the transitions of overinvestment-underinvestment cycles or commonly known as the Boom-Bust cycles.

Bear markets functioning as the other major market trend (other one being the Bullmarket) may constitute as either primary/structural/secular or secondary/cyclical/countertrend.

Primary-secular-structural bear market usually signifies the unwinding of previous excesses built up within the marketplace- as seen by massive overvaluation, speculative excesses (proliferation of margin trading) and “this time is different” euphoric attitudes- financed by too much debt or leverage in the banking system and or capital markets to the point of massive asset-liabilities mismatches which likewise reflects on major imbalances within an economy.

It may also represent fatalistic or defeatist government policies; remember the 5 cardinal sins-protectionism (nationalism, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Overall, structural or secular bear markets reflect internal or endogenous adjustments as a result from these malinvestments or bungled policies.

On the other hand secondary-cyclical-countertrends are simply trends that correct temporarily against a major trend. Remember since no trend goes in a straight line major trends are likewise confronted with major corrections, and this could be triggered by many superficial factors.

The Phisix has not been a stranger to bear markets. In the past twenty two years we have seen four bear markets which equally reflect both cyclical and secular or structural (see figure 1) phases.

The Cyclical Phases (as measured by peak to trough)

Following EDSA I, the Phisix soared by TEN times before:

1. August 1987 to October 1988- the Phisix lost about 45% and consolidated for 13 months before recovering and resuming another attempt to the upside. The trigger for the bear market in 1987 – ex-Col. Honasan’s August 28^th Black Friday’s botched coup d'état against erstwhile President Cory Aquino.

2. November 1989 to October 1990- the Phisix lost about 62% in about 11 months before convalescing. The trigger for the bear market of 1989 -November 30^th Makati coup again by ex-Col. Honasan.

The aftermath to the last cyclical bear market saw the Phisix soar by over 5 times to its 1997 high of 3,447.

As you can see, political upheavals such as the past aborted coup attempts could serve as triggers to bear markets.

The Structural/Secular Phase (as measured by peak to trough)

Figure 2: IMF: Asia: A Perspective on the Subprime Crisis

Figure 2 from IMF’s Khor Hoe Ee and Kee Rui Xiong reveals of the similarity between today’s subprime debacle in the US and the 1997 Asian experience.

Abundant liquidity, massive capital inflows, overcapacity from overinvestments, loose credit standards, soaring assets fueled by leverage, inordinate foreign currency debts, conflicting interests from participants (agency problem) and moral hazard among others have been enumerated as main contributors to these pair of boom bust cycles.

In the Philippine financial markets, the angst from the fundamental adjustments of the 1997 crisis was mainly expressed via massive price revaluations as the sharp depreciation of the Peso, the collapse in real estate prices and the initial collapse of the Phisix.

Again what must be remembered was that even if the bubble popping contagion was seen from a regional perspective, the imbalances brought about by the above factors was seen in the construct of the domestic economy and in the local financial markets. In short, the bubble was internally generated as much as it reflected the region’s activities.

This leads us back to figure 1, the secular bear market of the Phisix…

3. February 1997 to October 1998-the Phisix lost 66% in about 20 months. But following the election of President Joseph Estrada, the cyclical Presidential honeymoon period led to the Phisix rebound of 120%. This could be interpreted as the cyclical bullmarket within the secular bear market.

4. July 1999 to November 2001- the Phisix lost 62% in about 28 months for the culmination of the secular bear market cycle. Oddly, the Phisix appear to trace the developments in the US markets or when the Nasdaq dot.com bubble imploded in 2000, for a huge chunk of this cycle.

From the above we learned that it is very important to distinguish between the basic compositions of market trends. Why? Because, the torment from a secular bear market relative to the cyclical bear market is far worse in terms of depth (longer duration for adjustments) and scale (larger degree of losses). Thus you can make your portfolio adjustments to reflect on the risks involved once you can categorize which part of the cycle we are into.

In general, the internal market configurations and domestic economic structural dynamics determine the adjustments reflected in the financial markets from which demarcates the cyclicality or secularity of a given trend.

Alternatively, this means that if today’s problems emanates from exogenous factors then unless it becomes severe enough to fundamentally alter the present economic and financial landscape, we should expect the present bear market to represent the cyclical nature of today’s underlying market trends.

No Bubble: A Reprise!

Have we been in a structural bubble? No, as we scrupulously argued in Phisix: No Bubble! Time for Greed Amidst Fear.

Figure 3: IMF: Improving Balance Sheets and No Property Bubble

Even IMF’s Khor Hoe Ee and Kee Rui Xiong argues in their piece that balance sheets of corporate debt levels have been markedly improving in Asia, aside from modest property appreciation seen relative to the advances in Europe and the US see figure 3.

But there are always exist some form of risks most likely coming from a contagion, quoting Mr. Khor and Mr. Kee (highlight mine),

``Even so, Asian policymakers must watch for remaining risks from the subprime crisis that could pose problems for Asia. These include what a Standard & Poor's report called a possible "triple whammy" on banks: more subprime-related losses, an adverse impact on Asian financial markets that affects banks, and an adverse impact on Asian economies that affects banks.

``But to date, such impacts seem muted. Asian banks are engaged in traditional bank lending and are not heavily exposed to the more sophisticated types of financial products that have hurt financial sectors in many industrial countries. However, a decline in the real economy as a result of economic declines in the United States and Europe could cause a significant deterioration in the quality of bank loans.”

Since the banking system has been the foremost conduit for the financing of most the Asian economies, all eyes should now focus on how banks will adjust to the ensuing downdraft in the economic growth of developed countries or from the junctures of rising “inflation”.

This I think is what the global financial market has thus far priced in, aside from the ongoing delevaraging process that has fomented the forcible selling of most liquid asset classes by institutions caught in the web of illiquidity stasis.

And if Asia is not a bubble then the likelihood is that the bear market arising from the present contagion conditions as mentioned above could be likewise be cyclical and temporary in nature. If our analysis is correct then we should see the rendition of the same patterns even amongst our neighbors.

Vietnam climbed about EIGHT times from late 2003 and has corrected 66% over the past 8 months. Today, the much ballyhooed “next China” seems to be healing (but needs further confirmation) and is up 20% from its most recent lows.

India likewise soared nearly FIVE times over the past four years and is down nearly 40% from the peak and could see still some selling pressures. Whereas China’s Shanghai index skyrocketed 4.5 times since only 2005 (or a bullmarket of about 2 years old!) and has surrendered 57% of those gains (based from its recent peak prices).

Meanwhile, our neighbor Indonesia has climbed about 4.5 times also since 2003 and has contracted by 32% during the first panic in August of 2007, but interestingly remains above this level. The JKSE is also presently above its April lows (-23% from peak) and is today down by about 20%.

On the other hand, our Phisix has trailed all of them up by only 280% from June 2003 to October 2007 and has touched the 40% threshold of losses just the other week.

Another, in a structural bear market practically all issues are supposedly headed for the gutters, but this isn’t the case today. In fact some issues have been trading within their 2007 highs: namely, Pilipino Telephone (PLTL), Petron Corp (PCOR) and Oriental Petroleum (OPM), or at near historical highs Manila Water (MWC), Philodrill (OV) and Semirara Corp (SCC).

Again these are empirical evidences that today’s bear market is cyclical in nature.

The point of this exercise is to show you the following:

1. Relativity of the performance of the previous upside and the present downturn matters. Market trends are generally determined by the longer term trends and are usually impeded by intermittent secondary or cyclical-counter trends.

2. Experts usually use existing headline information to account for present market actions but whose analysis can be shown NOT TO BE CONSISTENT with the broader market picture or if taken from a macro perspective. To quote self development author Robert Ringer, ``A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

3. Since people by nature are hurt by the prospects of pain more than the delight from future gains-this accounts for a cognitive bias called LOSS AVERSION- thus, losses tend to be fast and furious, even during cyclical markets due to the impulsive nature of investors.

4. If the recent losses signify cyclicality and not structural impairments then the gist of the losses appear to have been priced in for many of Asian markets (Barring any massive shocks from external channels, e.g. stock market crash in the US or UK). This is not to imply that they can’t go lower. What we mean is that the scale of losses will probably be much lesser from this point on or the degree of losses could be in the process of culminating.

5. The cyclicality, tendency to overshoot, false premises and relative performance combines to reinforce the likelihood of a faster than expected recovery.

6. Finally we are not in the practice of financial voodooism to suggest when exactly the turning point will be. From our perspective, using the lessons of the financial history, we should use the present crisis as an opportunity to grab worthwhile investment themes which are likely to be selective given the present character of heightened risk aversion.

To quote PIMCO’s co CEO Mohamed El-Erian (emphasis mine),

``Today's markets are particularly tricky as they provide the duality of both great opportunity and enormous risk. And in contrast to recent years, investors will not be able to appeal to a few macro themes; be they bullish ("the great moderation" and "goldilocks") or bearish ("debt exhaustion" and the collapse of structured finance). Instead of the phase of highly correlated market moves, up and then down, we will witness the gradual assertion of fundamental differentiation between market segments and for instruments in the capital structures…

``This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion.”

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."