Are Stock Market Prices Driven By Earnings or Inflation?

``All political thinking for years past has been vitiated in the same way. People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome. Political language... is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind.” -George Orwell, 1984

Theory, Experience and the Consensus Thinking

My first venture into this field gave me the impression that stock market prices had been fundamentally driven by company earnings. Thus I worked my way into the learning the ways to “project” earnings. Now years after, I’ve come to the conclusion that the importance of earnings is secondary.

Yet, such mindset continues to reflect on the consensus thinking. As most of the books, the preaching of the academe and especially the orientations of my peers that are regularly communicated either verbally or through transcriptions via newsletters persist to influence the investing public.

Nonetheless, during the early days, from a strict “fundamental” standpoint, experience altered my perception of the markets. Going along with my contemporaries, I was made to believe that profits involved NOT only earnings, but from special activities as “deals or mergers”. So the goal now shifted from studying corporate fundamentals to one of ascertaining advance information from insiders, and correspondingly took bets on them.

And obtaining insider information meant networking with many people, which prompted me to join forums and groups. Unfortunately, the hunt for financial glory, which turned out to be a profit tryst was nothing but systematic punt and which ultimately taught me an expensive and emotionally agonizing lesson when the market reversed.

Nevertheless during the heydays of the 90s and the subsequent depression, I came to realize too that there had been some blatant inconsistencies with what is understood by consensus based on the dogma of “earnings-as-drivers” and from those acquired through experience.

I realized that on good times everyone seemed energized as the stock market levitated, and on the contrary, during bad times, everyone was either somber or looking for a new endeavor outside the stock market.

Market Tides And Stock Prices

It was then from the classic book “Reminiscences of A Stock Operator” of Edwin Lefèvre or a.k.a the legendary Jessie Livermore that my empirical observations was reinforced.

Remember this Edwin Lefèvre quote which we used to warn of the transitioning bear market in 2007,

``I NEVER hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to think. It is too much bother to have to count the money that he picks up from the ground.”

In contrast to mainstream brokers who ceaselessly bombard you with the hackneyed “earnings-as-drivers” of the market, market reality shows otherwise (see figure 1)

Figure 1: Market Tides Applies to the Phisix Sectors and the World

The upper window is the performance of the sectoral or industrial indices of the Philippine Stock Exchange which spans from 1996 to the present. Do you notice of any material divergence? The answer is none. (chart index: green-Mining, blue-Properties, black-Bank, pink-Commercial Industrial, red-Holding, red orange-service)

The point is stock prices in general, as rightly observed by Mr. Lefèvre, sink or swim depending on market tides.

Do you not wonder why speculative issues or even shell companies greatly outrun cash flow backed fundamental issues during bullmarkets? Or has there been any domestic stock issue (speculative or blue chips) that has been spared from today’s grizzly bear market?

Case Study: Robinsons Land Corporation

Let us make an actual comparison. I will use Robinsons Land Corporation (RLC) as an example. My choice of RLC came about out of availability, it is the company that last reported a disclosure on January 23 (I don’t own RLC) and is likewise Phisix component.

According to the company’s disclosure, “audited consolidated net income by the end of the fiscal year 2008 (October 2007 to Sept 2008) amounted to Php 3.15 billion, up 29% from the same period last year.” Even in 2007, the same figures showed a 42% growth.

On the other hand, its stock prices have COLLAPSED EVEN AS REVENUES CONTINUE TO CLIMB, albeit at a slower DOUBLE DIGIT pace. RLC prices peaked on February 2007 at Php 23 and closed at Php 4.8 Friday or a loss of an astounding 79%!

Yet if stock prices function as forward discounting mechanism based on future earnings streams then the recent stock price trend of RLC conveys a message of a very steep collapse of revenues and earnings, possibly similar to those in the US. Remember, RLC’s stock price slump has been two years old (in 2007 +1.5%, in 2008 -70%)! Usually markets are ahead of fundamentals by 6 months.

And at the close of November of 2008, which is not far from where RLC last traded Friday, according to the PSE, RLC has a dividend yield of 9.14%, 154 basis points higher than the Philippine government 10 year bond (!!!), a price-to-earnings of 5.82, a price to book of .73 and a debt equity of .78.

So the point is, if the market is CORRECTLY pricing future earnings then the company’s balance sheet and income will deteriorate tremendously over 2009 almost 24 months into the RLC price summit. On the other hand, the market may NOT have been reflective of the fair market value of the company and has been INFLUENCED BY OTHER FACTORS HARDLY CORRELATED with the company’s fundamentals.

And if we apply the same logic, the Philippine benchmark the Phisix or the PSEi which has lost nearly 55% from peak-to-trough, has a dividend yield is 5.63%, a PE ratio of 9.76, Price to Book at 1.28 and debt equity of 2.78. Yet the collapsing stock market doesn’t square with the economic figures which registered moderate but POSITIVE growth and NOT a recession.

In short, evidence defies consensus thinking. (I have seen the same story in 2002)

Bubble Cycles Defines Today’s Risks Environment

And curiously we see the same developments overseas. Going back to the chart, from 1999, seen from the lower window, exhibits some of major global benchmarks-S&P 500 (black), Brazil’s Bovespa (blue), Japan’s Nikkei (violet), Hong Kong’s Hang Seng (red) and the Phisix (green)-have ALL moved synchronically.

You might object, but what about my old mining and oil issues that became wall papers? Doesn’t this signify the need for fundamentals?

Well the answer to that question is shown in figure 2.

Figure 2: Cyclical nature of Commodity prices over 200 years

Let us put this into perspective.

This isn’t simply a matter of “speculative” issues that had gone kaput. The fact that Enron, once the 7^th largest company in the US, went bankrupt in 2001, today’s quasi nationalization of the world’s former 18^th largest public company in American International Group (AIG), the bankruptcy of Lehman Brothers, founded in 1850 (!) and was the fourth largest US investment bank, the forced merger of Bear Stearns-also founded in 1923 and was one of the largest US investment banks- with JP Morgan and importantly, the DEMISE of the US investment banking industry (Economist) or the transformation of its relics to bank holdings, only goes to show that whether it is a defunct speculative mining issue in the 1980s or erstwhile blue chip behemoths as today, they are subject to the risk influences of bubble cycles.

And an unwinding bubble cycle,

1. strips the CHIMERICAL INVINCIBILITY of industry leaders (e.g. US investment banks, real estate industry, mortgage lenders and etc…),

2. unmasks FRAUDS and corporate SKULLDUGGERY (e.g. Madoff and Enron) and

3. bankrupt UNVIABLE companies (old speculative mining issue)…

…all of which had been founded or built upon unsound business models.

The Philosopher’s Stone

Bubble cycles are shaped by monetary policies which are aimed at inciting PERMANENT boom conditions by omniscient ‘Powers That Be’, particularly interest rate manipulation.

Yet defying basic economic laws, when interest rates are forced below market levels or at the rate at which the demand for and supply of capital are equalized, excess credit, which the central bank creates, unduly expands demand for assets. Worst of all, by discouraging or even punishing savings, it encourages expanded risk appetite or speculation.

In other words, business projects that shouldn’t have existed at all are given false signals from which they rush in to take advantage of.

Yet, the ensuing illusionary boom distorts the capital structure and overvalues the currency through the intertemporal misallocation of resources or malinvestments, thereby increasing unpredictability into entrepreneurs’ plans. Moreover, an overvalued currency induces a shift of manufacturers overseas.

Hence, the onrush of demand for assets lowers the demand for money which leads to increases in interest rates and which ultimately impacts the feasibility of these unsound business model based companies.

Hence, the boom eventually turns into a bust, where according to Ludwig von Mises, ``The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”

Nonetheless some invaluable insights from the late University of Vienna Professor Fritz Machlup (1902-1983) in The Stock Market, Credit and Capital Formation, on the tight relationship between inflation, bubble cycles and the stock market (bold emphasis mine):

-A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.

-Extensive and lasting stock speculation by the general public thrives only on abundant credit.

-Abundant funds, especially those of inflationary origin, may not find ready outlets in real investment.

-Any decrease in the effective supply of money capital is likely to cause disturbances in the production process.

-An inflated rate of investment can probably be maintained only with a steady or increasing rate of credit expansion. A set-back is likely to occur when credit expansion stops.

-The use of credit for financing working capital does not assure "self-liquidation" or liquidation free of disturbance. For the economy as a whole circulating capital mostly constitutes long-term investment and, if the volume of production is to be maintained, even permanent investment.

-The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn.

-If bank reserves are controlled by the monetary authorities, credit inflation should not be attributed to the stock-exchange boom. However, margin regulations may be an effective means of checking the expansion.

Conclusion and Recommendations

Overall, here are our observations and recommendations:

1. Seen from the overseas perspective, the transmission mechanism of inflationary policies from the US abetted by global policies geared towards financial globalization or the facilitation of cross border capital flows have narrowed national idiosyncrasies (decoupling) and reinforced synchronization of movements among major global stock market benchmarks (integration) during the recent boom cycle.

The same reverse effects from the credit bubble deflation can be seen today unfolding around the world today. And this convergent stock market deflation theme even applies to most of the US markets (see figure 3) or even to Warren Buffett’s flagship Berkshire Hathaway’s portfolio.

Harry Markowitz, the economist who popularized the Modern Portfolio Theory appears to have been invalidated with the recurring inflation deflation cycle. Today’s market conditions reveal that “diversification” under inflationary policies hasn’t been applicable…yet.

Figure 3: Gavekal: Deflating Margin Debt=Deflating Stock Market

2. Edwin Lefèvre’s empirical observation that individual stock prices move in the general direction of the markets is greatly supported by the role of central bank policies.

3. Monetary authorities have been aware of the significance of this stock market-inflationary policy relationship; hence have partly crafted policies in support of such outlook. As evidence, US Federal Reserve Chairman Ben Bernanke wrote in his A Crash Course for Central Bankers, ``History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

4. Inflationary/deflationary environments shape risk taking appetites. Under loose monetary conditions or boom cycles, augmented risk appetites translate to a stretching for yields. This also means that the selection breadth by market participants of the asset horizon widens.

In general, like tea poured into a teacup that is filled to the brim, the tea spills over to the saucer and eventually out to the table and to the floor. An easy money landscape extrapolates to a “rising tide lifts all boat” as excess money diffuses to the general market.

And conversely, when the liquidity tide goes out or in bust cycles, you will learn that many have been caught swimming naked (estimated $30 trillion in 2008), to paraphrase the world’s best stock market investor Warren Buffett.

5. Because the Philippine stock market is largely underdeveloped, have low penetration level of exposure, have low degree of sophistication and whose domestic participants have inadequate understanding of the markets and thinks that they are some form of “gambling casinos”, an inflationary environment extrapolates to surging speculative activities which often directs punts to high volatile “issues”.

6. In advanced and sophisticated markets as the US, the weightings of “earnings as driver” may have bigger contribution to pricing relative to underdeveloped markets but as the Berkshire Hathaway portfolio shows has been impacted by the inflation deflation cycle.

7. Unlike typical brokers who will frame and impress on the public with the “earnings as drivers” theme, our advice is to understand not so much of “micro” fundamentals and “market timing”, but more from the unorthodox standpoint of comprehending the market, economic, political-inflationary and business cycles. Markets ultimately as seen today are driven by inflationary actions in the era of fractional standard based modern central banking.

8. Most brokers spread the wisdom of “earnings-as-drivers” theme but tacitly intend to induce trades, where earnings do not seem to matter. They will ask you to open a position based on fundamentals (e.g. PE ratio) and close the same position based on price actions (e.g. sell on resistance). Remember, “fundamentals” and “technical price actions” are distinct tools in approaching the market. Avoid the confusion by identifying, planning and implementing these tools (one or the other or a mix of) before going into any trade/investment.

9. Lastly Professor Fritz Machlup drives a very important point about the prospects of recovery, he says ``The start of a general business upswing can be financed out of surplus cash balances without an expansion of bank credit. The temporary surplus cash balances, dishoarded at the beginning of the upswing, are set free again when the crisis is liquidated; they are then disposable for another upturn”.

Again against consensus thinking, SAVINGS AND NOT CREDIT is likely answer for the recovery.

San Miguel’s Shifting Business Model: Risks and Opportunity Costs

``An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”-Benjamin Graham

We recently read with interest how San Miguel has been scaling down on its Beer business model and has been phasing into the energy sector gradually.

Note: Our comments here are not intended for any recommendation but serves as to analyze on the possible opportunity costs of the shifting corporate strategy of the second largest publicly listed company (technistock.net) of the Philippines.

Although we are not clear about the details of the proposed changes in the structure of ownership of San Miguel, Japan’s Kirin Holdings which has reportedly acquired a cumulative 19.7% stake in the company in 2001 and 2005, is reportedly in talks to acquire a majority share.

According to Finance Asia, ``Japan’s Kirin Holdings and San Miguel Corporation yesterday announced that they have signed a memorandum of understanding which includes an exclusivity clause for Kirin to acquire a further 43.25% stake in San Miguel Brewery. No financial details were disclosed, but based on San Miguel Brewery’s last traded share price, the stake is estimated to be valued upwards of $1.25 billion.”

Yet, recently San Miguel [SMC: SMCB] acquired the 27% stake of the Philippine Government Service Insurance System (GSIS) in Meralco (abs-cbnnews.com) and a 50.1% stake in Petron from a London-incorporated investment fund Ashmore Investment Management Ltd while dabbling on the idea to enter the telecoms industry with Qatar Telecom (gmanews.tv).

Thus, San Miguel’s business model is being overhauled over a very short period of time.

The Risk Variables

From our point of view, the shift in San Miguel’s corporate strategy comes with the following risk variables:

1. Competency risk. As the company veers away from its métier, it will incur a learning curve. While the company may “acquire” experience to reduce the costly interfacing of such learning curve, the drastic changes in the business path could entail some challenges in the operational, management and or corporate culture by way of frictions.

2. Country concentration risk. San Miguel which used to diversify its business internationally seems to be putting all of its eggs into one basket-banking on the Filipino consumers.

3. Restrained Profits. The consumer based energy industry is a heavily regulated industry with attendant regulatory profit caps. Meanwhile growth prospects are likely to follow the growth conditions of the local economy’s growth.

4. Political Risks. Extreme price changes in consumer energy could lead to highly volatile social mood swings. In times of political extremities, where governments can turn “outside-in”, the risk of nationalization could play a significant ‘sword of Damocles’ over the company’s new business model.

5. Late Mover Disadvantage. The telecom industry is a highly competitive capital intensive environment. Trying to gain market share from the existing players at time where the mobile user’s penetration level is at 60% seems quite challenging. It would be better for the company to acquire one of the existing players or adopt a ‘pail and shovel’ approach by introducing technology related which could cater to the industry.

The Opportunity Cost

San Miguel’s decisions will also mean lost opportunities. And this will include the loss of capitalizing on:

1. Asian consumption growth.

While today’s financial crisis is expected to hurt consumer spending everywhere, it is simply part of the business cycle which ultimately will segue into a recovery.

From our point of view, today’s crisis should be used as an opportunity to position for such cyclical transitions and eventually reap on the rewards of the prospective dynamism of the fast growing region.

According to the Economist in 2007, ``CHINA has the world's biggest thirst for beer, comfortably outstripping the country in second place, America. But the Chinese market is highly fragmented. Around half of all the suds sold in America is produced by Anheuser-Busch, brewer of Budweiser. Snow, China's most popular cold one, commands only around 5% of that country's market.”

Figure 4: Economist: Top TEN Beer Markets

In short, a fragmented market in a rapidly growing economy like China can translate to enormous potentials to secure added market share and expand profits.

2. Currency regional currency gains. Exposure overseas extrapolates to revenues in localized terms. With our expectations of Asian currencies to appreciate over a longer horizon, the potentials of such currencies gains could compliment profits will be missed.

3. Exploit Other Global Opportunities. San Miguel could have used the present opportunities to expand into consumer related industries parallel to their field.

The Boston Global Group in their 2008 New Global Challengers identifies the possible success dynamics for companies in Rapidly Developing Economies (RDE) over the coming years, see figure 5.

Figure 5: Boston Consulting Group: 2008 New Global Challegers

According to BCG, ``Our analysis of the 2008 BCG global challengers reveals globalization dynamics that are already affecting every market and industry, reshaping the world’s economic landscape.”

The BCG candidates for the world’s fastest growing companies come from mostly the BRIC (Brazil, India, Russia and China) zone. While our neighbors have some representative Indonesia (1), Malaysia (2) and Thailand (2), the Philippines have none.

The 6 BCG models quoted from Atlantic community

``1. Taking RDE Brands Global: Having established their brand identity in their home markets, companies attempt to take their brand global. Usually their expansionary growth is entirely organic, as witnessed at India’s Bajaj Auto or Brazil’s Nature cosmetics.

2. Turning RDE Engineering into Global Innovation: Low labor costs and strong R&D performances offer RDE companies global competitive advantages, as with Brazil’s Embraer, the world’s third biggest aviation company.

3. Assuming Global Category Leadership: Faith in their own product’s strength drives some of the challengers to an attempt to assume a leading role in their line of business. China’s battery producing BYD has successfully realized such a strategy.

4. Monetizing Natural Resources: Spurred by soaring commodity prices, the challengers can increasingly use mergers and acquisitions (M&A) to expand globally and to secure viable growth. An example would be India-based Hidalco’s recent purchase of Canada’s Novelis.

5. Rolling Out New Business Models to Multiple Markets Companies such as the Mexican mobile-network operator America Movil adapt their branding and marketing strategies to different regions, while retaining their basic business model. This has allowed them to expand their business into new markets while localizing operations in each.

6. Acquiring Natural Resources Assisted by their government, some challengers — especially Chinese ones — focus on securing their access to resources to ensure long term growth.”

Basically, San Miguel’s main opportunity cost is the cost of globalizing its business model.

There could be two possible angles from which we suspect could have shaped these strategy shifts:

One, the San Miguel management believes that recent globalization trends might be reversed over the long term and thus has positioned defensively by going domestic or

Second, the company’s chairman Eduardo Cojuangco Jr., who is founder of the National People’s Coalition and has ran against Fidel V Ramos for the 1992 presidency but lost, could possibly have politically associated strings to these acquisitions with the 2010 elections only a year away.

Burgernomics: 2008 Financial Crisis Cheapens Asia's Big Macs

According to the Economist, ``THE dollar's recent revival has made fewer currencies look dear against the Big Mac index, our lighthearted guide to exchange rates. The index is based on the idea of purchasing-power parity, which says currencies should trade at the rate that makes the price of goods the same in each country. So if the price of a Big Mac translated into dollars is above $3.54, its cost in America, the currency is dear; if it is below that benchmark, it is cheap. There are three noteworthy shifts since the summer. The yen, which had looked very cheap, is now close to fair value. So is the pound, which had looked dear the last time we compared burger prices in July. The euro is still overvalued on the burger gauge, but far less so than last summer."

True. Applied to Asian currencies, after a nearly broad market rout during the last semester (see below from ADB Bond Monitor), except for the Japanese Yen and China's remimbi, most of the region's purchasing power parity computed Big Mac Index became more affordable relative to the US dollar. Thus, the region's currencies are likely to have more potential exchange rate value appreciation over the long run.

Credit Default Risk Update: Bond Vigilantes Around the Corner

An updated list of credit default swap (CDS) prices and changes to default risk based on 38 countries courtesy of Bespoke Invest.

In general, sovereign default rates have been higher.

But the biggest the surge in default risks on a year to date basis have been in European countries, particularly in Ireland which jumped 58%, Belgium 53%, Spain 52% and Portugal 51%.

And the banking based financial turmoil has weighed heavily even on its major European economies as Germany, UK and France.

The regional pecking order of default concerns appears to be: Europe, Latin America and Asia.

Fortunately, the Philippines have so far had inconsequential changes.

Perhaps recent success of its latest bond offering which had been well received was reflected by such the seeming equanimity of CDS spreads (see see Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?).

The following is the table of CDS prices…

In terms of CDS prices, according to Bespoke, ``As shown, Argentina and Venezuela have the highest default risk, followed by Iceland, Kazakhstan, Russia, and Egypt. While the UK and US have relatively low default risk compared to most other countries, their CDS prices are getting worrisomely high. At the start of 2008, it cost about $8 to insure $10,000 of UK and US debt. It now costs $135 to insure UK debt and $75 to insure US debt. Japan has the lowest default risk of all of the countries highlighted, followed by Germany and France.”

As far as we are concerned, the Bond vigilantes seem to be lurking around the corner.

Top 10 Global Business Risk

A report by Ernst & Young and Oxford Analytica vets on what they perceive as the top 10 business risks for 2009.

The report had been based from the “views of more than 100 analysts from around the world and more than 20 academic disciplines”, according to Research Recap.

The list as follows:

And the distribution of risk concerns applied to major industries…

Read the entire report here

US Politics: Extrapolating Hope and Change to Presidential Term Realities

In politics “hope” and “change” are common catchphrases which may help serve as a useful ticket to winning elections.

According to the Economist, ``BARACK OBAMA is fond of hope and change. By one tally, he said “hope” nearly 450 times in speeches delivered on the campaign trail. (By contrast, his rival John McCain only used the word 175 times.) “Change”, too, was a campaign buzzword. In his inaugural speech Mr Obama made three mentions of hope and only one of change (plus a “changed”). He mentioned America seven times, followed by “work” and “common” (six times each).

``While hope has found a place in each of the 26 inaugural addresses, change is used more sparingly. Seven inaugural speeches did not contain the word; six more made use of it just once. Presidents coming to office during economic booms, such as Calvin Coolidge and Warren Harding in the 1920s, Dwight Eisenhower and then George Bush junior, have been heavier users of hope than those who were inaugurated during leaner times.”

The Economist list the number of times “hope” and “change” were used in all previous presidential inaugurations.

Why the prominent use of hope and/or change by politicians? To market themselves…even after elections.

As Seth Godin explains, ``The reason is simple: people need more. We run out. We need it replenished. Hope is almost always in short supply.

``The magical thing about selling hope is that it makes everything else work better, every day get better, every project work better, every relationship feel better. If you can actually deliver on the hope you sell, there will be a line out the door. Hope cures cynicism. Hope increases productivity. Hope needs no justification.”

Yet, marketing and delivering promises are two distinct things. In the political sphere, sloganeering can be possibly shaped by the prevailing economic conditions or by just plain rhetoric.

To advance this perspective, we will attempt to get some clues by comparing these to several indicators.

But we will have to narrow the Economist list starting from 1953. The abridged ranking is as follows:

1. Dwight Eisenhower (1953,1957), 2. George Bush Sr (1989), 3. George Bush Jr. (2005), 4. Richard Nixon (1969), 5. Lyndon Johnson (1965) 6. Ronald Reagan (1985), 7. John Kennedy (1961), 8. Harry Truman (1949), 9. Ronald Reagan (1981), 10. Bill Clinton (1993, 1997), 11. George Bush Jr. (2001), 12. Jimmy Carter (1977) and 13. Richard Nixon (1971).

And we will concentrate on the top 5 heavy political rhetoric (PR)…

Chart Federal Reserve of Atlanta

From the GDP standpoint there seems to be little correlation between the top PRs and economic rate of change.

What seems noteworthy however is that the GDP volatility had been materially been narrowing from the Eisenhower to the Reagan Period (1953-1981) compared to the Reagan to Bush era (1981-2009).

Chart Federal Reserve of Atlanta

The next chart is the measured against unemployment.

The top 4 out of 5 PR Presidents: Eisenhower, Bush Sr., Bush Jr. and Nixon saw unemployment surge as their inaugurals nearly coincided with the US economy’s transition to recession periods.

Only President Lyndon Johnson presided over a declining unemployment rate.

But noticeably for the two term Presidents in Eisenhower and George Bush Jr., the trend had mostly been up during their entire tenure!

Chart from Wall Street Journal

The above chart from the Wall Street Journal exhibits the approval ratings during their tenure.

Some noticeable points:

-Harry Truman and George Bush Jr. had the highest approval ratings but spectacularly collapsed at the culmination of their term.

-George Bush Sr., who also had a surge in ratings possibly due to the Iraq war, likewise saw a sharp decline but not as steep as George Bush Jr. or Harry Truman.

-Dwight Eisenhower, who oversaw a sharp rise of unemployment, managed to end his term with exceptionally high approvals rating similar to Bill Clinton. Could this be due to the Korean war?

-Except for President Bill Clinton every past Presidents saw lower exit ratings compared to when they assumed office but the degree of variances are dissimilar. Nonetheless, in his inaugural address, Bill Clinton had the highest use of the word "change" among the Presidents.

-only George Bush Jr. seemed to score low in terms of popular ratings combined with a tenure of rising unemployment.

The high approval ratings can be expressed in terms of public approval of perceived actions or satisfaction of economic conditions or influenced by nationalistic fervor (war, 9/11 etc.) or expectations of hope or change and cannot be directly measured as economic performances.

Yet high approval ratings tend to be followed by a collapse over the years.

Finally we find no strong general association between political rhetoric and economic performance or whether politicians delivered the goods they promised.

Superman Gordon Brown: The World's Savior?

In a session at the House of Commons last December, England's Prime Minister Gordon Brown goofs about saving the world....errr the banks. (source: Telegraph).

Anyway this just an example of F. Hayek's 'Fatal Conceit', or the overweening belief of one's omniscience. A good quote from Thomas Sowell, ``Politics is largely the process of taking credit and putting the blame on others-- regardless of what the facts may be. Politicians get away with this to the extent that we gullibly accept their words and look to them as political messiahs."

Low Hyperinflation Risk For the US?

According to some analysts, the risk of a Zimbabwe like hyperinflation to happen to the US dollar is slim if not implausible. Because the idea is, once 'inflation' gains a footing and eventually overcomes 'deflation' it will be easier to control.

Perhaps. But such is giving too much credit to the ability of authorities to steer us out of trouble.

But before acceding to such premises, it is best that we must try to understand Zimbabwe’s hyperinflation model.

We quoted Albert Makochekanwa of the Department of Economics of the University of Pretoria, South Africa in our Will Debt Deflation Lead To A Deflationary Environment?, who wrote in his paper “Zimbabwe’s Hyperinflation Money Demand Model” the following: ``Borrowing from Keynes (1920) suggestions, namely that ‘even the weakest government can enforce inflation when it can enforce nothing else’; evidence indicates that Zimbabwean government has been good at using the money machine print. Coorey et al (2007:8) point out that ‘Accelerating inflation in Zimbabwe has been fueled by high rates of money growth reflecting rising fiscal and quasi-fiscal deficits’. As a result of that, the very high inflationary trend that the country has been experiencing in the recent years is a direct result of, among other factors, massive money printing to finance government expenditures and government deficits.”

So, exploding DEFICITS…

From caseyresearch

Plus a jump in government payrolls which has surpassed the private sector, which further entrenches government spending...

Source: contraryinvestor.com (Fabius Maximus)

Plus, a soaring growth money supply, which according to Jeff Tucker of Mises.org seems starting to respond…And importantly a snowballing clamor for the printing press:

Previously we posted Ken Rogoff see Kenneth Rogoff: Inflate Our Debts Away!

And now:

From Peter Boone and Simon Johnson (Wall Street Journal Blog)…

``The Fed should announce that it will create inflation in 2009, i.e., it will do whatever it takes to make sure that wages and prices rise, rather than fall, in the next 12 months. And it should back that up with more aggressive monetary expansion, buying even more government and private securities. We cannot wait for a deflationary death spiral to take hold

From the Economic Times…

``There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalization, inflation is the ultimate way to spread the costs of debt workout across the widest possible section of the population.

And at ZERO interest rates, ``we are entering a world with interest rates that are far too high for the economy's good," Goldman Chief U.S. Economist Jan Hatzius wrote in a Jan. 16 research note.” (Businessweek)

``The solution is obvious: The Fed needs to deliberately raise the rate of inflation—maybe not all the way to 6%, but significantly above zero. One way to do that is to print lots of money. The Fed can create money from thin air by purchasing assets such as Treasuries and mortgage-backed securities and paying for them by crediting the seller with newly created reserves at the central bank.” writes Peter Coy of Businessweek

Essentially Dr. Gideon Gono of Zimbabwe seems to be gaining quite a following among personalities in Wall Street, the academe and in the media...Aside from of course, public authorities like Mervyn King Governor of the Bank of England who will likewise do a Gono.

As for the risk of hyperinflation in the US or elsewhere, I’d rather be guided by Ludwig Von Mises in Human Action p. 427….

``But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”

``It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.”

Niall Ferguson: Ascent of Money

Great educational stuff on "money" and today's crisis by Niall Ferguson

The Good and Bad Sides of a Global Car Sales Slump

The recent sharp slowdown in global economies apparently had also been reflected on a crash of car sales.

According to the Economist, ``NO COUNTRY or company has been immune from the collapse in car sales. Figures released last week confirmed that the last half of 2008 saw the most savage contraction in demand for motor vehicles since the second world war. In America sales of cars and light trucks in December fell by 33.5% compared with a year ago, and in Spain they crashed by nearly half. Even in Brazil and China, where sales increased on an annual basis compared with 2007, saw sharp declines in the last quarter of 2008. Of the world's big carmakers, Chrysler is in the most trouble, thanks to poor products and a reliance on the American market, where its sales dropped by more than any other carmaker.”

So falling car sales equals an inventory pile up.

Here is a visual account or a sample of the on going slump- a parade of surplus Peugot cars.

For more pictures of unsold cars check out the Guardian.

There are two sides to every coin...

While this accounts for as BAD news for automakers and the ancillary industries…

this should signify as GOOD news for consumers as car prices fall significantly!

A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino

This article is dedicated to my friends at RC Mandaluyong.

People normally bear the misimpression that stock markets function as some variant of gambling “casino”.

Never have they realized that stock markets bear a significant financial and economic merit. Any country that desires to adopt some degree of market based economy requires the presence of a stock market. Even in places which are deemed as economically, socially or politically chaotic or unstable such as Iraq, Zimbabwe or Nigeria has an operating stock market.

Basic Function

The stock market operates similar to the markets where we buy our food. Basically both of these markets function as platforms for conducting exchanges between buyers and sellers. The difference is in the products traded. For our “conventional” markets, it is based on comestible stuffs and or other household wares, whereas for the stock market they involve corporate financial securities such as common stock or preferred stocks or Exchange Traded Funds (ETF).

Going deeper, stock markets- as part of the capital markets- often reflect the basic function of money as medium of exchange, unit of account and a store of value.

-they function as a platform to trade financial securities (medium of exchange),

-they serve as a repository of collateral since they represent ownership in companies that are backed by assets and stream of revenues (store of value) and

-they are valued through the pricing mechanism whether these are driven by momentum or emotions, corporate fundamentals or micro/macro economy as “inflation” (unit of account).

Since all financial markets are driven by the price mechanism, the following variables represent as key drivers in ascertaining prices:

-a collective assessment of the fluctuating balance between demand and supply

-accounts for the subjective value judgments by market participants

-signifies the time dimension in shaping for market participants expectations, whether it short medium or long term, and lastly

-primarily influenced by psychological dimensions (such as greed or fear) and cognitive biases (such as overconfidence, anchoring, risk aversion etc.)

And because markets are determined by divergent psychological expectations they result to a variable flux in prices as seen in the tickertape. This is known as volatility.

Yet prices are always set on the margins. What you read on the stock market section in the newspapers account for as prices determined by marginal investors, where daily traded volume represent only a fraction of total shares outstanding or market capitalization, and not the majority owners.

And the resultant price volatility set by marginal investors is what accounts for as the conventional impression of gambling “casino” like actions.

Risk and Uncertainty

The common impression of the public is that price fluctuations or volatility are a function of sheer randomness. And because of the perception of such unpredictability they are deemed to be risky, which adds to the gambling misperception.

But as market savant James Grant says, ``The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price.”

Of course, whether it is stock market or any non-financial enterprise or even public governance the fundamental problem will always be tomorrow’s uncertain outcome. We can’t even be certain if we will see the sun shine tomorrow. As an old saw goes, there is nothing certain in this world except death and taxation.

The point is- the aversion to the stock market is generally not about its unpredictability, but about having an insufficient understanding of how markets operate. To quote, the world’s richest and most successful stock market investor Mr. Warren Buffett, ``Risk comes from not knowing what you are doing.”

Yet if one scrutinizes the market, it can be generally observed that markets rarely operate on random.

This makes uncertainty of the future a measurable component. The same uncertainty is what can be translated to as “risk” or a “state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome” to quote economist Frank Knight.

In addition, compared to a dice toss, or a bet on a lottery, or a horse race which is immediately determined by the end result of one particular event, markets can be distinguished from these high return high risk activities, because they operate as a continuing process.

This makes time a significant contributor to risk assessment.

From the distinguished finance author Peter L. Bernstein, ``Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

Reward Risk Tradeoff

Everyone wants to profit. But in financial or stock markets or in any “market based” entrepreneurship endeavor, profits come by as returns of investments (ROI). In other words, one has to accept some degree of risk in order to generate profits.

Applied to regular business enterprises, this also translates to same dynamics: risk capital has to be deployed, in the expectations of future stream of revenues, which fundamentally determines your return on capital. The difference is that in the stock market as a shareholder, you become a passive investor.

Yet because we are uncertain about tomorrow, there is always the risk of undesirable or adverse outcome in the marketplace.

Again like any entrepreneurial activities, success or failure in the stock market always entail offsetting risks relative to your capital to determine your expected returns. This is what is known as the Risk-Return Tradeoff.

Put differently by understanding and limiting your risk, you can amplify or optimize your returns.

This brings us to the basics of risk identification. Fundamentally, there are 3 major risks to consider;

-systematic risks or market risk- risks to the general stock market such as government policy repercussions as war, protectionism, regulatory overkill, monetary policy mistakes, excessive taxation or risks of an economic recession or risk from bubbles: asset-liability mismatch seen in domestic balance sheets or in currency framework or overleverage in the financial or economic system etc…

-residual common factor risks or risks relative to a specific industry such as industry directed regulations, tariffs, etc... and lastly,

-residual specific risks (e.g. risk relative to a particular stock or company such as profitability, management, labor, inventory, etc…)

This means that once the above risks can be assessed, which correspondingly may determine one’s risk reward profile and subsequently applied to the configuration of a portfolio mix, the much feared losses can be minimized while the profit opportunities optimized.

Let me cite a common example; some financial institutions as banks offer Unit Investment Trust Funds (UITFs). Such investment vehicle essentially accounts for as fiduciary fund generally designed to cater to an investor’s risk appetite. But the portfolio mix is standardized; it is offered in either foreign (US dollar) or domestic (Peso) denominated funds and generally split into a choice of equity, fixed income (bond or money market) or balance fund (50% equity-50% balance).

For an investor of the UITF it means 3 things:

First, passive investment-investment allocation is determined by the fund manager assigned for a particular portfolio distribution. Your risk reward ratio is subject to the fund manager’s risk distribution activities. This means your portfolios performance is also subject to management risk.

Two, since the balance of accepting risk is standardized; a choice of all fixed income (conservative risk taking), balance fund (moderate risk) and equity fund (aggressive), the unforeseen risk is the opportunity cost of being “flexible”. In short, a standardized portfolio could be deemed as rigid.

Lastly, a foreign currency denominated fund means expanding your risk spectrum to include the currency risk or volatility from currency valuations.

However in an actively managed portfolio, you can apply the same risk allocation strategies, but this time, being more malleable to your risk profile and time frame based returns expectations.

Market Cycles

Whether we talk about economics or markets, we always deal with psychology.

It is because people act, based on their perceived values or priorities or guided by incentives, to attain certain desired ends.

Thus, the prevailing social psychology, as reflected in moods and actions, underpins the economic activities of savings-consumption-investment decisions, aside from cycles in the financial markets.

Here is an example of flow of the psychological cycle that drives market and or economic cycles.

Generally speaking, since people as social beings, we tend to act in crowd like fashion. This essentially forges extreme swings from outright optimism to downright depression, brought upon by our base instincts of “fear and greed”.

Applied to the economy we see the same wavelike movement…

Thus, economic trends transit from recovery, prosperity, contraction and recession which defines the general economic cycles, and which are nearly identical with the flow of the public’s social moods or psychology.

And as mentioned earlier, stock markets are likewise driven by crowd psychology. This in essence determines the price actions. And because crowd psychology is shaped by time influences, such invariably leads to trends which determine what is known as the stock market cycles.

The stock market cycle can be identified as bottom, advance, top and decline. In the above, the Philippine Phisix chart since 1980 shows that we appear to be undergoing a second leg of a long term cycle.

Again whether it is the stock market, or real estate or any asset class subjected to price actions, they are all influenced by the general trends of psychology.

The same can be applied to boom-bust cycles.

Boom bust cycles account for as the extreme flow of fund swings to certain industries which are typically manifested or vented on financial markets. Boom cycles are usually fueled by massive credit expansion, overspeculation and euphoria, while the bust cycles are the opposite of boom cycles; credit contraction, massive losses from liquidations, liquidity constraints, retrenchment of economic activities or plain risk aversion.

The present bust in the US, preceded by a boom in its housing industry, is emblematic of this phenomenon.

Speculation and Economic Benefits of the Stock Market

Because we can’t foretell of the future accurately, any act of capital allocation basically represents as speculative activity. But where the difference lies, again, is in the degree of volatility. A dentist may have less volatile flow of patient visits compared to a businessman engaged in distribution of cellphones.

However, most speculative actions in the marketplace are always associated with short term movements. Yet, unknown to most, the speculative component helps increase the liquidity or tradeablity of a security or markets, which essentially produce greater pricing efficiency or reliability of market price signals.

Remember, price signals function as our principal incentives for deciding how to allocate resources which can be seen in the context of saving, investing or consuming.

Finally, there are other economic benefits that the stock market provides to the society:

1. The stock market is a vital part of the process from which we coordinate production. Ideally stock prices should reflect the productivity of business firm aside from market’s discernment of the entrepreneurial judgments concerning future productivity.

2. It competes with the banking sector in determining the degree of mobilization of savings into investment. From a national scale this becomes a formidable channel for economic advancement in terms of efficiency of capital deployment.

3. Unknown to many, stock markets often function as forward indicators, such that they have been known to predict upcoming recessions or prospective recoveries. Thus, movements in the financial and stock markets can give a clue to the transitioning business environment, which should help management or businessmen, in allocating resources or in applying their business strategies going forward.

4. It operates as alternative avenues for fund raising (public listing), intermediation (using shares as collateral for borrowing-lending) or liquidity generation (buying or selling a company).

5. Because the markets operate as an organized platform of exchange, the ease from a market’s liquidity allows companies to save on transaction costs: search cost (matching buyers and sellers), contracting costs (cost of negotiation) and coordination cost (meshing securities of different industries into a single platform), which frees up capital for other usage.

6. Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.

7. Allows some individuals to save from taxation (e.g. inheritance taxes)

8. Because stock markets function as repository of collateral or store of value, it can serve as protection or safehaven against hyperinflation or a severe form of a loss of purchasing power of a currency.

In the case of Zimbabwe where (hyper) inflation rate has reached an astounding 231,000,000%, its stock market has skyrocketed 960 QUADRILLION percent on a year to date basis as of November 4^th, (All Africa.com) considering more than 5 years of severe economic contraction and 85% unemployment rate. Unfortunately because of some political reasons, the Zimbabwe Stock Market has been suspended since December 17^th (Bloomberg).

Stock Market Is Generally Not A Casino Until…

The overall the goal of this article is to enlighten the public from the mistaken notion that stock markets generally represent as gambling casino.

Given that the stock market has measurable risk-reward variables, involves time continuum dynamics and value added functions (as dividends) it operates like any entrepreneurial undertaking.

Moreover, it has an economic wide and social significance which is largely unappreciated by the uninformed public.

Hence, the speculative ‘casino’ trait is often associated to individual actions or participants who engage in the markets with a short term outlook and without the proper understanding and scrutiny of risk. [Further reading please see Professor Alok Kumar of McCombs School of Business, University of Texas in a recent paper, Who Gambles in the Stock Market?]

Lastly of course government interventions can tilt or distort any markets away far from its price signaling efficiency. This is where the level of the playing field or the distribution share of the odds are skewed to favor one party over the others, mostly the recipients or beneficiaries from these interventions. Where the governments assume the role as the HOUSE and the beneficiaries as the DEALERS, then all other participants operate as PLAYERS, hence your basic description of a gambling casino.