US Political Economy: History Repeats Itself

In our previous article Has The Barack Obama Presidency Been Driven By Market Dynamics?, we posited that activities in the marketplace, which has been reflective of present and future economic dimensions, may have served as an important psychological driving force to voter selection during elections.

Apparently, we learned that this hasn’t been the first time.

According to the Economist, ``ONLY twice since the 1920s has economic angst played such an important role in a presidential election—and both the previous occasions make imperfect templates. When Franklin Roosevelt defeated Herbert Hoover in 1932, the Depression had been going on for three years, thousands of banks had failed and unemployment was 25%. When Ronald Reagan beat Jimmy Carter in 1980, inflation had been high for years, hovering at 12% as voters headed to the polls. By contrast, the crisis facing Barack Obama has been underway for just over year, with unemployment standing at 6.5% according to figures published on November 7th.” (underscore mine)

Let us take a look at how the markets performed during the aforementioned periods.

The Dow Jones Industrials prior to the FDR-Hoover 1932 Presidential elections

Chart courtesy of Chartsrus.com

The S&P 500 prior to the Reagan-Carter 1980 Presidential Elections

Chart courtesy of chartrus.com

As Charles Kindleberger wrote in Manias, Panics and Crashes A History of Financial Crises ``For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."

Emerging Markets Stocks Reveals Deep Value

The rapid selloff in the global markets has led to massive adjustments in corporate valuations in emerging markets.

What used to be deemed as "pricey" has now turned to near "fire sale" prices.

According to Jack Dzierwa, Global Strategist of US Global Investors (emphasis mine),

``First, as we’ve said earlier, it’s important to not lose sight of fundamentals, which in the long run will be the driving force in the markets. In terms of valuations, the trailing price-to-earnings ratio hit an all-time low of 6.5x in mid-October, with an equity risk premium of 1,100 basis points.

``It is likely that investors are noticing these compelling valuations, as in the last two weeks higher stock prices in the emerging markets universe have driven trailing P/E up to 8.2x. While these P/Es have risen, emerging markets are still trading at a 27 percent discount to the developed markets universe.

Current valuations represent signs of morbid fear than of reality.

As of last week, the Philippine benchmark, the Phisix, according to the table below from David Fuller of fullermoney.com (HT: Prieur Du Plessis) shows dividend yields at 6.36%, PE at 9.05 and P/B at 1.4., compared to Indonesia’s 5.31%, 7.11 and 1.5, while Malaysia 6.15%, 9.67 and 1.3.

From current depressed levels, it is without doubt why Templeton's Mark Mobius believes that ``I think the markets will rejuvenate much faster than many people realize"

I share his view.

Default Risk: The Philippines Ranks 12th

The following chart from Bespoke Investments exhibits the order of default risk among nations as determined by the cost of insuring the local sovereign debts via the Credit Default Swap (CDS).

According to Bespoke Investments ``These prices represent the cost per year to insure $10,000 of debt for five years. We also show what the prices were at the start of the year. Of the G-8 countries, Russia has by far the highest default risk with a CDS price of $523. That's higher than any of the struggling banks we highlighted yesterday. Japan, France, the US, and Germany have the lowest default risk of the group of countries, but they have all spiked more than 200% this year. Argentina is in the most trouble, with a cost of $4,453 per year to insure just $10,000 of debt. Venezuela is the second worst at $2,016, followed by Lebanon, Egypt and Indonesia." (highlight mine)

The Philippines is ranked 12th and is about 200 basis points away from Indonesia. However, looking at the start of the year figures, the Philippines rose by only 265 basis points compared to Indonesia's 485, while Malaysia and Thailand saw significant increases too but at less the pace than ours at 185 and 165 basis points, respectively. Although if seen from the perspective of % change from the start of the year, the Philippines would account for the least.

Yet we can't deny that by being the 12th, this means the CDS markets believe we are one of the more vulnerable countries in the heightened risk aversion landscape.

The Rise of Value Investors Amidst A Prevailing Fear and Loss Environment

``If stocks are attractive and you don't buy, you don't just look like an idiot, you are an idiot.'' -Jeremy Grantham, Baron Buys, Grantham Spots `Once in Lifetime' Chance

It is a curiosity to occasionally hear questions about profitability in today’s market similar to “Are you up or down?”

Because for as long as people have positions in the financial market whether directly (equities, fixed income, currencies, commodities) or indirectly (mutual funds, hedge funds, ETF, UITF and etc.) the unequivocal answer is that given today’s downside volatility-losses are the rule, not the exception.

Today’s Fad: Losses Everywhere

Think of it; nearly $30 trillion of market capitalization wiped out from global equity markets year to date alone. Banks have written off about $680 billion and still counting. As we earlier argued in Spreading the Wealth? Market IS Doing It!, the political morality polemics about income inequality has been in a wash since market losses appear to have sizably narrowed the controversial gap.

Still world real estate market continues to bleed; in the US estimates of losses have been at $1 trillion (globeandmail.com). We don’t have the collateral damage estimates or casualty figures from the fallout in other markets, most especially in Europe and in some other parts of Asia, which includes China or Japan or Australia.

Nevertheless, we have also enormous unaccounted for losses in the derivative, currency (a roster of emerging market victims from Reuters), commodities, bonds, structured finance and other financial markets.

Retirement accounts of baby boomers have been nursing some $2 trillion in the deficits (msnbc.com), thereby putting in jeopardy the retirement plans of many Americans. With Americans likely to work longer, apparently the incoming Obama presidency would have to deal with policies related to health insurance costs, Social security and Private Pensions and flexible work arrangements to address the challenges of the coming transition.

Moreover, the losses have now been spilling over to the real economy enough to impact corporate bottom lines and dividends. In the US, according to the Howard Silverblatt of S&P (Businessweek), earnings growth which had originally been optimistically forecasted at 14.2% for the third quarter have so far posted 13.9% in the red with 77% of companies reporting.

And by corporations we also mean major pension funds and retirement institutions.

As an example many Filipinos are familiar with the US largest retirement fund, The California Public Employees Retirement System, known as CalPERS, which accounted for a total portfolio value of $185 billion on Friday, down 23% from $239 billion at the start of its fiscal year. (latimes.com). The CalPERS fund is down by nearly $54 billion.

According to the same article, ``CalPERS "is taking hits across all asset classes," Feckner said. But the losses would have been even greater "if we had not spread our money out" by diversifying investments….For now, working with interim executives, CalPERS is sticking with a strategy that leans heavily on stocks, which account for about 40% of its holdings. No decision has been made about shifting the investment mix -- possibly toward bonds and other fixed-income assets, Feckner said.” (emphasis mine)

The point is; much like the CalPERs experience, investing in markets is NOT about “trying to time the markets”, as to literally assess one’s portfolio as being “up or down”, but applying portfolio management across the company’s risk profile and time horizon objectives.

In addition, President Rob Feckner underscores the viciousness of the present bear market as impacting “across all assets” meaning that the collateral damage has been broad based and severe enough for most investor’s to escape its wrath.

Warren Buffett Has Been NOT Immune

Figure 1: stockcharts.com: year-to-date performance of Mr. Buffett’s Berkshire Hathaway

Because of ferocity of the bear markets, not even gurus are immune.

We have spilled so much ink about the wondrous feat of the world’s most successful investor Warren Buffett, but viewed from real world developments, Mr. Buffett’s investments have not been entirely unaffected see Figure 1.

On a year-to-date basis, Berkshire Hathaway has fallen victim to the powerful grip of bearmarket forces with its share prices down over 20%. And it is not just in share prices, but likewise reflective of corporate bottom line performance, with most of the damage emanating from derivatives related losses.

Some important highlights from CNN Money, ``Warren Buffett's Berkshire Hathaway Inc. on Friday reported a 77% drop in third-quarter earnings, hurt by declining insurance profits and a $1.05 billion investment loss…

``Berkshire began the year with an unrealized $1.67 billion loss on its futures, options and other derivative contracts. The value of those derivatives, which are tied to the value of the overall markets and the credit health of certain companies, improved in the second quarter by $654 million. But in the third quarter amid unprecedented market turmoil, their value fell by $1.05 billion, leaving a loss of $2.21 billion through the first nine months of the year…

``Berkshire finished the third quarter with $33.4 billion cash on hand. That is up from the end of the second quarter when the company had $31.2 billion cash on hand…

``Year to date, Berkshire's net worth slipped to $120.15 billion from $120.73 billion, but during October, price declines in investments and increased liability for equity index put option contracts accounted for a $9 billion decline in net worth.”

So similar to CalPERs, the troubles of Warren Buffett’s flagship in Berkshire Hathaway have been mainly due to the downside repricing of its asset holdings than from the direct impact of the economic downturn to its operations (yes, insurance and Berkshire’s Mid American subsidiary Constellation Energy has suffered from losses).

Remember, Berkshire Hathaway isn’t just your typical fund manager, but is an active investor to manifold diversified industries tacked into the company’s portfolio as subsidiaries, unlike CalPERs which functions principally as passive investors.

A second observation is that as we wrote in Warren Buffett Declares A BUY!, the recent months have shown Berkshire increasing its cash portfolio but over the year have plunked some $11 billion into the markets. Its cash holdings is still a significant 30% relative to the company’s overall net worth, but down from 40% at the start of the year when using the present net worth figures as basis.

Nonetheless, investments in the market doesn’t have to come directly from Berkshire as some of its subsidiaries have been doing the dirt work of expanding via acquisitions such as office furniture CORT which recently acquired Aaron Rents Corporate furnishing for $72 million (bizjournals).

So yes, while Mr. Buffett’s long term holdings are temporarily “down”, influenced by the gyrations of the market, aside from escalating impact from economic variables, overall, his portfolio’s direction has not been driven by the ridiculous idea of “ticker based” assessment but from the perspective of portfolio risk distributed allocation!

In Berkshire’s case, 60% exposure to market risks and 40% cash at the start of the year has changed to the direction of increasing exposure in market risk given the present conditions.

Betting Against Warren Buffet’s Oracle?

Figure 2: US Global Investors: Track Record of Warren Buffett’s Major Calls

Mr. Buffett hasn’t been your stereotyped market timer, figure 2 from US global investors shows how the legendary Warren Buffett has incredibly “TIMED” the market with his publicized calls to a near precision or perfection during the past 43 years!

Put differently, Mr. Buffett doesn’t exactly “time” the markets in a literal sense as market technicians are wont to do. His selling call in the late 90s didn’t come with outright liquidation of the entire Berkshire’s portfolio simply because some of his portfolio holdings had been designed as a “buy and hold forever”.

Although he did express some regrets for failing to do so, Mr. Warren Buffett quoted at PBS.org in 2004, ``We are neither enthusiastic nor negative about the portfolio we hold. We own pieces of excellent businesses -- all of which had good gains in intrinsic value last year - but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I.” (emphasis mine) So if the Oracle of Omaha had been subject to regrets, how much more the mere mortals of the investing world?

To reiterate, in periods where he believes markets are conducive for selling Mr. Buffett raises cash in proportion to his allocation targets and positions defensively. On the other hand, in periods where he thinks opportunities for greater returns with a margin of safety embedded on his risk profile, as he does today, he raises his market risk exposure gradually.

Yet, the Mr. Buffett’s rarified but highly prescient audacious landmark calls can be construed from a combination of his interpretation of economic cycles, fundamental valuations and importantly sentiment, the seemingly indomitable “simple-but-hard-to-apply” Buffett doctrine- ``be fearful when everybody is greedy and greedy when everybody is fearful”.

Given his formidable track record, betting against him isn’t going to be a prudent choice.

The Illusion of Bull and Bear Markets

It also to our understanding that gurus don’t see markets the same way ordinary market participants view them, like in the manner which we typically label as Bull or Bear Markets.

Mr. Nassim Nicolas Taleb, the famed iconoclastic author of the best selling book The Black Swan, wrote in Fooled by Randomness ``I have to say that bullish or bearish are often hollow words with no application in a world of randomness-particularly if such a world like ours, presents asymmetric outcomes.” (highlight mine)

Incidentally, Mr. Taleb has been one of the recent exceptions or outliers, whose managed funds have remarkably been up during the recent gore in the financial markets. This from Wall Street Journal, ``Separate funds in Universa's so-called Black Swan Protection Protocol were up by a range of 65% to 115% in October, according to a person close to the fund.”

While Mr. Taleb’s magic seems to work best with market crashes as he has done so in Black Monday of October 19^th 1987, he hasn’t been as effective when markets are going up, ``Mr. Taleb's previous fund, Empirica Capital, which used similar tactics, shut down in 2004 after several years of lackluster returns amid a period of low volatility.” (WSJ)

In parallel, Dr John Hussman recently wrote of the pointless exercise of classifying markets as bullish or bearish, ``From my perspective, the whole issue of bull market versus bear market doesn't get investors anywhere. Asking whether stocks are in a bull market or a bear market is like asking Columbus what kind of trees are planted along the edge of the earth. The question itself makes a false assumption about how the world works. My view is that bull markets and bear markets don't exist in observable reality – only in hindsight. What gain is there to investing based on something that's unobservable when you can manage your investments based on directly observable evidence? What we can observe directly is the prevailing status of valuations and the quality of market action.” (underscore mine)

In short, such gurus tend to view markets strictly in the context of fundamentals than from sheer momentum.

Conclusion

To recap, the sharp volatility in the financial markets has been the prevailing trend such that anyone exposed to the market has been subject to losses in the market directly or indirectly.

Even the biggest institutions or the best investors have not been immune from current adverse market developments.

While this is not to justify present losses in the essence of John Maynard Keynes’ famed pretext, ``It is better for reputation to fail conventionally than to succeed unconventionally", the point is to learn from the perspective of übermarket professionals that investing is not about attempting with futility to catch undulating short term waves but of shaping one’s portfolio based on risk distributed time preference profiles amidst observable evidence of market action and fundamental and or economic parameters.

Yet since the prevailing trend of losses has become a mainstream bias, a mounting chorus from value investors seems to have surfaced.

Warren Buffett’s recent contrarian buy calls may have either generated a momentum or provided justifications for the rising incidences of converts (from former bears into current bulls). We formerly listed Dr. John Hussman, Jeremy Granthan and Mohammed El-Erian as the early apostates.

We are adding to our list prominent market savants are Vanguard’s founder John Bogle, Fidelity International’s Anthony Bolton, former Merrill Lynch’s Bob Farrell, Steve Leuthold, Research Affiliates LLC’s Rob Arnott and others.

Even Dr. Marc Faber believes that the low is near but in contrast to the others believes global markets will ``stick at this low point for a long time.”

Yet, some of the rabid high profile hardcore bears whom have basked in the recent glory of market collapse seem to remain stuck with idea of market Armageddon.

But there seems to be one stark difference between the former (converts) and the latter: the former are full pledged money managers while the latter appears to be ivory towered ensconced members of the academia or publishers who aren’t money managers.

Demystifying the US Dollar’s Vitality

``The Achilles Heel of the United States is the dollar. The reserve status of the US dollar is absolutely critical to the health of the US. If the dollar begins to lose it's reserve status, the US economy will be in shambles.”-Richard Russell

Some have found the recent rise of the US dollar as mystifying while the others have found the surging US dollar as a reason to gloat.

While there are many ways to skin a cat, in the same way there are many ways to interpret the US dollar’s vigorous advance, see figure 3.

Figure 3: stockcharts.com: US Dollar’s Rise Coincided with Market Breakdowns

From our end, we read the action of the US dollar index (geometric weighted average of 6 foreign currencies of major trading partners of the US) by looking at its relationship across different asset markets.

And as we can see, the dramatic surge of the US dollar index coincides with an astounding symmetry-the collapse of the oil market (lowest pane) and the equivalent breakdown of critical support levels (vertical arrows) of stock markets of the US (signified by the S&P 500- pane below center) and Emerging Markets (pane below S&P).

And market actions have fantastically been too powerfully synchronized for us to ignore its interconnectedness or the apparent simultaneous cross market activities.

While we can discuss other possible influence factors such as the shrinking trade deficits which may have contributed to a narrowing current account deficit or an improvement in US terms of trade or the ratio of export prices over import prices, the fact that the US dollar behaved in a spectacular fashion can’t be interpreted as a sudden market epiphany over some unlikely radical improvement in trade fundamentals.

What we understand was that by mid July, cracks over the financial markets began to surface with the US Treasury publicly contemplating to inject funds to support both Fannie Mae and Freddie Mac. From then, the deterioration in the financial markets accelerated which inversely prompted the skyward ascent of the US dollar. Fannie and Freddie were ultimately taken over by the US government in September.

DEBT DEFLATION Dynamics In Progress

So what could be the forces behind such phenomenon?

``Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

``The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.”

This according to Irving Fisher is what is known as the DEBT DEFLATION theory dynamics. As you would notice the chain of events leading to the current market meltdown and the precipitate rise in the US dollar have closely shadowed Mr. Fisher’s definition.

How?

Figure 4: Bank of International Settlements: CDS and Foreign Exchange Derivatives Market

One, a significant market of the structured finance-shadow banking system (estimated at $10 trillion) and derivatives ($596 trillion, Credit Default Swap $33.6 trillion down from nearly $60 trillion-left pane- see figure 4) have mostly been denominated in US dollars (foreign currency derivatives also mostly US dollar denominated-right pane), thus deleveraging or debt deflation means the closing and settlement of positions and payment in US dollars.

This also implies whether the counterparty is from Europe or from Asians settlement of such contract means payment in US dollars. Thus, the sudden surge in demand for US dollars can be attributed to the ongoing debt deflation-deleveraging process.

Figure 5: Investment Company Institute: World Mutual Fund

Two, cross currency arbitrage or 'carry trades' have also significant US dollar denominated based exposures.

For instance US mutual funds in 2007 totaled US $12 trillion (see Figure 5 courtesy of ICI) with 14% of the total allocated to International Stock funds or $1.68 trillion.

We may not know exactly how much of these funds flows were borrowed in order to buy into international stock funds, but the idea is, once the margin call came, highly levered funds were compelled to liquidate their positions in order to repay back their loans in US dollars.

Isn't it ironic that the epicenter of the present crisis emanated from the US and yet the debt deflation dynamics prompted a gravitational pull to the US dollar? Had these been something resembling like an Asian crisis then such dynamics would have been understandable.

The US Dollar’s Hegemon and Threats To Its Dominion

Figure 6: Bill Gross: Going Nuclear

Lastly, we have always described the architectural platform of the US dollar standard as pillared upon the cartelized system of US banking network which extends to a syndicate of peripheral banks abroad or global central banks.

PIMCO’s chief Bill Gross in his latest outlook wrote a good analogy of this as a function of nuclear energy see figure 6.

From Mr. Bill Gross (all emphasis mine), ``Uranium-238 has something like 92 electrons circling its nucleus…And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. The electrons morphed into productive financial futures and derivatives of all kinds benefitting all of the asset classes at the outer edge of the #238 atom – stocks, high yield bonds, private equity, even homes and commodities despite their being tangible as opposed to financial assets.”

``This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.”

Since financial flows appear to have revolved around the foundations of the US banking system with its core at the US Federal reserve, the recent logjam in US banking sector caused a ripple effect to the peripherals via shortages of the US dollar, a liquidity crunch and a subsequent scramble for US dollars which triggered several crisis among EM countries whose balance sheets have been vulnerable (excessive exposure to foreign denominated debt or currency risks, outsized current account deficits relative to GDP, excessive short term loans or highly levered domestic balance sheets).

Thus, the paucity of US dollars has compelled some nations to bypass the banking system and utilize barter (see Signs of Transitioning Financial Order? The Emergence of Barter and Bilateral Based Currency Based Trading?) such as Thailand and Iran over rice and oil. Whereas Russia and China have announced plans to use national currencies for trade similar to the recently established Brazil-Argentina (Local Currency System).

The recent crisis encountered by South Korea (heavily exposed to short term foreign denominated debt) and Russia (corporate sector heavily exposed to foreign debt) seem to be prominent examples of the US dollar squeeze.

Figure 7: finance.yahoo.com: South Korea Won-US dollar

Understanding the present predicament, the US Federal Reserve quickly extended its currency Swap lines to some emerging nations as South Korea, which has so far resulted to some easing of strains in the Korean Won, see figure 7. However, we are yet uncertain about its longer term effects although it is likely that access to the US dollar should demonstrably reduce the liquidity pressures.

The important point to recognize is that some nations have began to acknowledge the risks of total dependence on the US dollar as the world’s reserve currency and/or its banking system. A furtherance of the crisis with the US as epicenter can jeopardize global trading and finance. Hence, some countries have devised means of exchange around the present system or have been mulling over some alternative platform.

Such developments are hardly positive contributory factors that would buttress the value of the US dollar over the long term especially as the US government has been throwing much weight of its taxpayer capacity to resuscitate and bolster the present system.

Mr. Ronald Solberg, vice chairman and lead portfolio manager of Armored Wolf, in an article at Asia Times online articulates more on this (emphasis mine),

``According to Goldman Sachs estimates, the US Treasury faces an unprecedented financing need in fiscal year 2009.2 Excluding funding requirements under the Supplemental Financing Program (SFP), they estimate 2009 FY issuance at $2 trillion compared to last year’s $1.12 trillion, which itself was already outsized. This prospective amount is driven by an estimated budget deficit reaching $850 billion, funding TARP purchases of up to $500 billion and the rollover of maturing debt equal to $561 billion.

``On top of these needs, it would not be unreasonable to expect additional SFP funding requirements of $500 billion, the amount already issued to date in FY 2008 used to recapitalize the Fed’s balance sheet. The magnitude of such funding requirements will test the operational efficacy of the Treasury, requiring increased auction size, frequency and expanding maturity buckets on debt issuance, and will likely extend through FY 2009 and into FY 2010, prior to these pressures abating. Perhaps even more ominously, issue size will severely test market demand for such an avalanche of debt.”

Conclusion

All these demonstrate the two basic factors on why US dollar has recently surged.

One, this reflects the US dollar’s principal function as international currency reserve and importantly,

Second, most of the leveraged assets markets had been denominated in US dollars. And in the debt deflation dynamics as defined by Economist Irving Fisher, ``Debt liquidation leads to distress selling and to Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes A fall in the level of prices, in other words, a swelling of the dollar.”

Finally, with US government printing up a colossal amount of money within its system (yes that includes all swap lines extended to other countries as de facto central bank of the world), financing issues will be tested based on the (supply) issuance of its debt instruments and the (demand) market’s willingness to fund the present slew of government programs from internal sources (US taxpayers and corresponding rise in savings) and or from external sources (global central banks amidst normalizing current account imbalances).

We don’t buy the idea that US debt deflation will spur hyperinflation abroad which could further bolster the US dollar. Monetary inflation doesn’t necessarily require a private banking system to extend credit and inflate, because the government in itself as a public institution can inflate the system through its web of bureaucracy.

Zimbabwe is an example. Its banking system seems dysfunctional: savers don’t trust banks, the government has been using such institutions to pay for government employee salaries yet have suffered from government takeovers, while some of the banks have engaged in forex accumulation than operate normally.

Basically, Zimbabwe’s inflationary mechanism is done via the expansion of its bureaucracy to a leviathan and the attendant acceleration of the printing press operations.

Has The Barack Obama Presidency Been Driven By Market Dynamics?

It has been my belief that today's market response in the US had been the classic “sell on news” following the victory of Sen. Barack Obama in the 2008 Presidential elections.

Why? Because as we earlier argued in US Presidential Elections: The Realisms of Proposed “Changes”, American voters appears to have been influenced by the market’s reaction than of markets responding to the election dynamics.

Here is what we wrote, ``The worsening bear market in stocks and real estate which seems reflective of the prevailing economic conditions appears to be a key driving force which have driven the US public into the open arms of the opposition. Also, the rash of the present bailout schemes appears to be feverishly fueling the “bailout culture” from which has boosted the opposition’s welfare based platform.”

Proof?

The following compares the election trends vis-à-vis the US S&P 500 benchmark.

Courtesy of intrade.com

The Intrade Prediction markets exhibits the following data:

1) Democratic candidate Sen. Barack Obama led significantly most of the time (blue line) since the second quarter of 2008.

2) Republican candidate John McCain (red line) grabbed the lead for a short period during mid August-mid September (pink circle). Incidentally this was the period where candidate John McCain (red line) surprisingly picked Alaska Governor Sarah Palin as running mate.

3) Senator Obama reclaimed the lead only in late September, incidentally a week after the Lehman Bros filed for bankruptcy.

4) The Obama lead invariably widened as the November elections culminated.

Then take a look at how the S&P behaved during the shifts.

courtesy of stockcharts.com

Our interpretation:

-As you would notice, the undecided American voting public has seemingly been swayed by the market’s collapse to join the bandwagon for an Obama election landslide.

-The market’s collapse seems to have spelled the crucial difference that catapulted Senator Obama to the Presidency. Put differently, market’s woes have extrapolated to Sen. Obama’s gains.

-Americans seemed to have rallied or gravitated towards Obama in order to seek some form of relief from the market’s meltdown. In short, the Americans have assumed the Obama Presidency as some sort of a “savior” or have digested the “change” theme as some sort of economic or financial placebo.

Henry David Thoreau once said that ``What is called resignation is confirmed desperation.”

We just hope that desperation do not translate to illusion this time around.

Congratulations to US President Elect Barack Obama.

Bear to Bull Converts: Merrill’s David Rosenberg Next?

This article from David Berman of the Globe and Mail (all highlights mine),

``David Rosenberg, North American economist at Merrill Lynch, acknowledges that he remained too bearish for too long after the stock market hit bottom in the fall of 2002. Now, he wants to learn from those mistakes.

``So, even though he believes that valuations are not yet compelling and the economy continues to deteriorate – key supporting evidence for why the stock market may have yet have hit bottom – he's keeping an open mind.

“While I am not yet of the mind to start turning bullish, I think it does pay to pay homage to the many legends out there who had been cautious or outright bearish, and are now starting to change their views that, at the least, the worst may be over,” he said in a note, pointing to Warren Buffett, Jeremy Grantham, Bob Farrell, Don Coxe, and Steve Leuthold.

``He also dug up some numbers to suggest that the bottoming out process tends to be just that – a process that occurs over time, with a number of tests that challenge the low points.

``“Now I don't want to get overly excited, but I may have discovered the Holy Grail in terms of identifying a ‘bottom' that is tried, tested and true as opposed to one that may be a trap,” he said.

``He examined 12 stock market troughs for the S&P 500 going back to 1932. There was always a retest of the lows. On average, there was a 35-day lag between the actual low and the interim peak; the initial bounce averaged 16 per cent. Then, the index goes through a testing process, which also lasts 35 days. During this testing process, three-quarters of the bounce from the low to the interim peak is reversed.

“So the entire bottoming phase – trough to interim-high and then to the retest of the low – usually lasts 70 days,” Mr. Rosenberg said.

“We only know for sure when the low was a fundamental low at one particular moment of time, and that is when the S&P 500 crosses above both the 50- and 200-day moving averages. On that day, the bull market becomes fully entrenched, no questions asked. All 12 times, the market was up and up a sizable amount the following year, by an average of 25 per cent.”

Lesson:

Merrill’s David Rosenberg is clearly having second thoughts about his “super bear” stance in the recognition of the growing crowd of authoritative apostates.

Yet, Mr. Rosenberg wants to be convinced from the market action angle.

His “holy grail” means that this bounce will encounter its next retracement from which should test whether the October 10 low will hold.

There is an approximate 70 days-constituting 35 days for the present upside and another 35 days to the next downside retracement-for the test cycle.

If the retracement fails to take down the October 10 lows then by Mr. Rosenberg’s metrics, the bottom in the US markets would have been established. And Mr. Rosenberg will probably give up his bear market hat for growing horns.

FEAR Index: 1987 versus 2008

Great chart from Bloomberg’s David Wilson:

From Bloomberg

From Mr. Wilson: ``The indicator is derived from prices of options on the S&P 100, as its name suggests. The current version, introduced five years ago, uses S&P 500 options and includes more contracts in the calculations. Their readings tend to be similar. The VIX closed yesterday at 62.90.

``In 1987, the old VIX behaved differently than it has this year because the plunge in stocks was ``a far quicker affair,'' Michael Shaoul, chief executive officer of Oscar Gruss & Son Inc., wrote yesterday in an e-mail. ``There was nothing like the same degree of economic problems at the time and no concerns about the global banking system outside of the fact that equity markets had crashed.''

``The old VIX peaked at 103.41 on Oct. 11 as the S&P 100 swung between a 3.2 percent gain and an 8.1 percent loss. The high was well below its record of 172.79 on Oct. 20, 1987, the day after the so-called Black Monday crash.”

From Chartrus.com: 1987 Crash

Stockcharts.com: Stock Crash 2008 Version

My comment: It is quite obvious that 1987 was a shocker. From the chart perspective, there was hardly any clue that a crash would occur.

This compared to 2007-2008, which had been in a slomo descending bear market until October. In other words, the 2008 bear market had essentially conditioned the public about deteriorating market and fundamental dynamics.

And if we go by “The Kübler-Ross grief cycle”:

Changing minds.com

The recent market crash could represent as the “Acceptance phase” or in stock market lingo “capitulation” phase.

Thus, the difference in the VIX index of 1987 and today was one of expectations.: people got dumbfounded by the precipitate “one day crash” behavior of 1987 (hence the sudden realization of vulnerability) whereas the 2008 crash had partly been a process of the Kübler-Ross grief cycle applied to the stock market.

Reflexivity Theory In Commodity Markets

People today have been reading too much of what George Soros calls as the "prevailing bias".

By prevailing bias we mean a self-reinforcing trend which tends to not only to influence market psychology through prices but also through “fundamentals”.

The prevailing bias is that the present "deleveraging phenomenon" has been lowering collateral values and in effect destroying “demand”. This feedback loop feeds into the thought process of having the decreased demand (in the real economy) resulting to even lower prices and further liquidation. So the vicious downside spiral. But where does it all end?

Basic economic laws tell us that the prices are determined by demand and supply curves, such that when the cost of producing commodities has fallen below the production cost, mounting losses will incentivize a curb in present production and suspend future projects as well, which equates to constricting overall supplies. So economic laws tell us that the present downtrend becomes a race to the bottom between supply or demand. The winner determines the price trend of the markets.

As discussed earlier in More Compelling Evidence For An Inflection Point in Commodities!, there had been increasing evidence of “supply destruction” in base metals and agriculture to the point where concerns have even shifted to HUNGER.

Let us give an example: take a look at copper

From Kitcometals

LME Warehouse Copper stocks have risen today to 1^st quarter 2007 levels when copper prices fell to only at around the $2,500 per lb levels then. Now prices are significantly below $2,000 per lb.

Yet copper production remains in a deficit from Jan-July by 54,000 tons (Reuters).

Nevertheless, the economic report from International Copper Group Study Group remains ambiguous,

``According to ICSG projections, a modest surplus of about 100,000 t is anticipated for 2008. The calculated deficit for the first half of 2008 of about 125,000 t is expected to be overshadowed by a 235,000 t surplus in the second half owing to seasonally weaker second-half consumption and a downturn in global markets. Although supply continues to be constrained, usage in the three leading consuming regions continues to weaken [China, the European Union-15 countries (EU-15), and the United States]. Preliminary projections for 2009 indicate a surplus of around 275,000 t (1.5% of usage). Note that in calculating global usage, China’s copper usage is based on its apparent consumption using reported data (production + net trade +/- SHFE stock changes) and does not take into account changes in unreported stocks [State Reserve Bureau (SRB), producer, consumer, and merchant], which may be significant during periods of stocking or de-stocking. However, newly-released data on Chinese copper stocks for 2007 has been incorporated into 2007 apparent consumption calculations, resulting in a downward revision to Chinese apparent usage and an upward revision to the ICSG world market balance for 2007, which now shows a surplus of around 295,000 t.

``ICSG recognizes that the current crisis in the financial and credit sectors may significantly alter current forecasts. Not only may global usage be reduced by a global economic downturn, but also credit constraints and altered feasibility analyses could reduce or delay expected new production. Therefore, we are cautionary as to the uncertain net impact of production and usage constraints on forward-looking market balances….

So ICSG is apparently caught in a dilemma between falling demand and falling supplies.

The market dissonance goes the same in the gold markets.

We understand that physical gold markets covering bullion and coins have rapidly been disappearing as buyers have seemingly scrambled to scoop up any available physical gold. Here are some articles:

Dubai runs out of gold on Diwali rush (October 29^th)

Bloomberg-Zurich Bank's Vault Is `Full to the Top' With Gold (October 15^th)

Bloomberg-Perth Mint Doubles Gold Output on Haven Buying (October 1)

Business Standard India Post rakes in Rs 2.6 cr from gold coin sales (October 31)

Evening Standard UK- Gold runs out in German rush (October 10th)

Timesonline.uk -Vietnamese seek the security of gold (October 27^th)

Or take a look at this commentary from Mark O'Byrne published at the fxstreet.com (highlight mine)

``Physical demand remains near record levels internationally with rising premiums for all bullion products and delays and shortages deepening. There are now little or no gold coins or bars (1 oz and 10 oz) available for immediate delivery throughout the world. There are no silver coins or bars available besides 1000 oz silver bars.

``Investors are paying far higher premiums to secure physical bullion and they are willing to wait 6 to 8 weeks due to the unavailability of gold coins and bars and as they have no choice but to wait if they wish to take delivery of physical bullion.

``This demand is being seen throughout the entire world but especially in the western world, in the Middle East and throughout the Indian subcontinent and wider Asia.

``As noted yesterday, gold supply continues to fall with gold mining production worldwide failing 6% during the first-half of the year compared with the first half of 2007. Totaling just 590 tonnes between April and July, global gold mining output was the lowest since 1996 according to data from the US Geological Survey.

``The Wall Street Journal reported of "phenomenal" demand in India where in just 3 weeks Indian investors bought nearly as much tonnage of gold as they did in the entire final quarter last year. In the first 3 weeks of October alone, more than 50 tonnes of gold was sold. Incredibly, during the whole of October - December quarter last year just 80 tonnes was sold.

``The Journal reported that "gold sales have picked up phenomenally...following consistent steep fall in equity markets which has boosted the demand for the metal as a safe investment option.”

From Stockcharts.com

So why has paper gold not followed?

We can only guess but surely the glaring disparities in the physical and paper market seems fishy or anomalous.

Governments have nearly been “everywhere” in the financial markets. So global governments could be attempting to "short" or tamper or manipulate the gold market or the entire commodities markets to paint the image of suppressed inflation which gives them the liberty to "hit the accelerator to the floor".

Besides with global governments have been running the printing press like mad, inflationary policies ultimately will reveal themselves.

Unfortunately the markets are far greater than the collective strengths of governments, such that economic laws will ultimately prevail.

This means commodity prices are likely to go higher.

How the reflexivity theory might work?

And since the Reflexivity theory is a two-way feedback mechanism between cognitive and participating functions, where cognitive function runs from outcomes to expectations while participatory function runs from expectations to outcomes, the idea of economic laws determining prices is largely a participatory function from the present market conditions.

Since we expect fundamentals to eventually reassert itself, then commodity prices should hit bottom and begin to advance soon. Once the series of advances regain traction and following, the public will attribute stories of economic "recovery" to reinforce the convalescing trend. Thus, the feedback loop shifts from participatory to cognitive functions.

From here, the nascence of the upcoming "inflation" nightmare will also regain momentum.

Likewise rising commodity markets when supported by rising markets elsewhere will provide further reinforcement to such feedback loop.