Why The Presidential Elections Will Have Little Impact On Philippine Markets

In this issue:

Why The Presidential Elections Will Have Little Impact On Philippine Markets

-Patronage Based Political Economy And The Fantasy of Change

-Minor Changes Won’t Cause Mass Uncertainties

-China And Regional Integration As Growing Influences To Domestic Political Trends

-Seasonal Patterns Of The Philippine Presidential Cycle Reflects On Fed Bubble -Policies

-Summary and Conclusion

Last week a friend asked if the upcoming national or the Philippine Presidential elections would have a perverse effect on the domestic market.

My reply is, why so?

Isn’t this what the people want, a “perceived” change in the leadership? So how can such percipient “change” translate to a net negative for the asset markets (stocks, bonds, real estate peso)? This may be true if a radical left leaning (or even a communist) candidate looms likely as the new leader, but this isn’t likely to be the case.

Patronage Based Political Economy And The Fantasy of Change

In the survey of leading candidates that are within the ambit of winning the electoral pageantry, all of them hail from the political elite strata. This suggests that none of them are likely to “rock the boat”, since they have all benefited from today’s environment.

What you and I are most likely to see is only a change of the guards and NOT a change in the welfare based patronage rent seeking system.

It’s equally the typical voter’s delusion to see a “clean” government when an awesome and fantastic eye-popping amount is being spent for the “marketing” these candidates![1]

Common sense or dispassionate reasoning will never add up to the voter’s faith.

Gargantuan money spent for elections are NOT for altruism purposes but as investments that will be recompensed, or translated into returns on investments (ROI), by virtue of covert political privileges: concessions, subsidies, monopolies, rebates, commissions, tacit partnerships etc...

And it isn’t a question about who among the candidate spends most, but about HOW THESE EXPENDITURES WILL BE REDEEMED!!

Does one ever think that the vested interest groups in support of their candidates (or even the candidate him/herself) will be satisfied in merely getting back of their investments once they are successful in capturing the highest office of the land-which incidentally is endowed with a huge discretionary public fund and with the ultimate say on how the swelling public coffers should be dispensed with?

The primary reason for people to invest or risk personal money is to profit from risk opportunities. Since elections are risk opportunities in the political spectrum, so the realistic and commonsensical answer is a NO!

The fact that using directly or indirectly public funds to offset private campaign expenses is most likely to signify largesse from a booty! But who cares? It is usually the political outcast or its “fall guy” equivalent who carries the brunt of “social justice” to somewhat satisfy the expectations of the masses for virtue.

Moreover, in the aftermath of elections, we are likely to see alliances forged from among the opposing camps with the winner. This will be a fodder for publicity that would project magnanimous efforts by the winners to “unify” the nation. In actuality, these will be designed to suppress or contain the opposition, by indirectly buying them by allowing them to recoup campaign expenditures!

Besides since democracy is a popularity contest, isn’t it quite obvious that all candidates will not only ride along with the most popular issues but likewise take upon a centrist or non radical stance just to lure votes?

Public choice economics calls this the “median voter” theorem. William F. Shughart II writes, (bold highlights mine)

``If voters are fully informed, if their preferred outcomes can be arrayed along one dimension (e.g., left to right), if each voter has a single most-preferred outcome, and if decisions are made by simple majority rule, then the median voter will be decisive. Any proposal to the left or right of that point will be defeated by one that is closer to the median voter’s preferred outcome.”

In short, what you see and hear in campaign platforms, isn’t what we are going to get.

People hardly ever learn from history.

Popular Presidents as the current incumbent US President Barack Obama has seen a steep decline in approval ratings in just one year in office.[2]

Former Philippine President Joseph Estrada, who walloped former rivals by a landslide in pluralistic victory in 1998, was ousted in the 2^nd chapter of People Power’s revolution in 2001, about halfway during his tenure.

The former president, who had been pardoned by outgoing incumbent Philippine President GMArroyo in 2007, is now one of the many challenger-aspirants to the crown this May, perhaps in a quest for personal exoneration.

Minor Changes Won’t Cause Mass Uncertainties

It is unfortunate that people can’t seem to differentiate between what truly matters and what has been a longstanding fable.

Wall Street Street Journal Op-ed columnist Daniel Henninger, who argues for a return of the Robber Barrons, aptly identifies on such nuances,

``Market entrepreneurs like Rockefeller, Vanderbilt and Hill built businesses on product and price. Hill was the railroad magnate who finished his transcontinental line without a public land grant. Rockefeller took on and beat the world's dominant oil power at the time, Russia. Rockefeller innovated his way to energy primacy for the U.S.

``Political entrepreneurs, by contrast, made money back then by gaming the political system.”

In other words, Filipinos ought to realize that an environment of political entrepreneurship, the transference or the sucking out of taxpayer’s money from productive market activities to non-productive ventures due to the dispensation of political privileges or patronage economics, will unlikely provide for any material improvements in the system.

It is market entrepreneurship that is required for our economic upliftment.

And once the ball of “political entrepreneurship and paybacks” gets rolling, who or what should serve as “check” to sufficiently restrain abuses? Media?

Unless we are so gullible to “swallow hook line and sinker” the bunkum of media’s puritanical traits, the truth is media is just another self-interested agent that could be laced or infected with partisan politics or embroiled with conflicts of interests with that of public welfare. A recent example is ABC’s reporter Brian Ross caught lying in video in attempt to stage manage his Toyota death ride.

Hence, electing new leaders with fundamentally the same set of guiding incentives to prospective political actions do not actually trigger an abrupt systematic shift in the underlying nature of our political economy.

In short, the old aphorism “the more things change the more they remain the same” will most likely be a realistic application for today’s evolving political trends.

Thus, the outcome from the upcoming elections is unlikely to generate massive uncertainties in the market given the implied policies of continuity.

Yet public expectations from the “lotto” mentality of delusional “change” based on personality based politics will translate to effectively having “the rubber meeting the road” epiphany, post-elections. And this is the principal reason why ratings of populist leaders tend to collapse thereafter. Reality will expose that the emperor is naked.

And that’s why I’d prefer to see a tightly fought election so as to reduce the odds of the winning party to ‘confidently’ impose polarizing radical interventionist measures in the mistaken belief that a popular mandate backs their actions.

China And Regional Integration As Growing Influences To Domestic Political Trends

Figure 1: DBS Research: Changing Composition of Asian Exports

A one major positive (hopefully) structural factor OUTSIDE the range of political elections is that the Philippines, despite being a reluctant participant, has been enlisted in ASEAN’s pursuit of a free trade zone with China[3] (see figure 1)

As you will note from the above chart, the changes in the trade composition of the Asian-8 nations; namely Hong Kong, Taiwan, Singapore, Korea, Malaysia, Indonesia and Thailand aside from the Philippines, has materially shifted- where the chunk of its business is now with China than from the US.

And given this increasing prospects of deepening regionalism, this is likely to also manifest in the direction of regulatory and political trends- hopefully against the prospects of a surprise emergence of a clandestine zealot socialist leader.

This means that China will likely have an increasing influence in shaping our political order at the expense of the US.

This also means that we should expect the course of our domestic political affairs to tilt its balance towards the incremental accommodation to greater integration of trade, finance and investment and migration, with the region, as the opportunities from the ramifications of free trade presents itself.

And this does not entail the need to mimic the Eurozone’s route towards integration, as fund manager Andrew Foster of Matthews Asia writes,

``Developing a unified monetary framework within Asia Pacific is unlikely in light of the region’s history; the region holds too many memories of conflict and mutual distrust. Forging a unified currency out of such a construct is even less likely. However, what may occur is a gradual and de facto harmonization of interest rate cycles, dictated by the business cycles of the largest economies in the region. This may ultimately prove to be a more sustainable union. While a political project would likely fail to get off the ground, Asia’s currencies and interest rate cycles may align based on underlying trade flows, capital markets and other linkages in the real economy.” (bold highlights mine)

So yes, political and monetary integration may not be feasible at the moment, but what matters most is for the economic environment to operate freely.

Although I’d be more optimistic for Asia to adopt China’s yuan (the renminbi) as a regional currency reserve especially once the impact of monetary inflation from OECD policies becomes increasingly evident on the markets. And this will also depend if China has taken the necessary steps to avoid the same path.

China needs to only hasten the convertibility of her currency which implies more liberalization of capital flows to compliment the region’s free trade covenants.

Of course, for us, one possibility to defuse a ballooning endogenous bubble is to allow for liberalized capital flows as money trapped by capital controls has been forced to bid up domestic asset prices. Nevertheless, there is hardly any anti-bubble measure that is likely to succeed for as long as her government continues with its ‘accommodative’ money printing policies.

Meanwhile, I don’t think a political integration is a realizable option for Asia. Perhaps not until there will be cultural immersion and integration from substantially increased migration flows and or intermarriages. Such prospects are likely beyond our lifetime.

I’d also reckon that the new Free Trade Agreements (FTA) as more of open markets/market liberalization measures, as they are not “free trade” in the theoretical sense.[4]

Lastly, based on the above premises, it seems foreseeable that domestic political actions will likely be in response to the pressures extended by external forces, through the evolving changes in the macro picture than from internally impelled initiatives, unless the next batch of political stewards will resist or fight rather than accept these trends.

As economist Peter Boettke writes about Transitional Economies[5], ``The scourge of successful reform efforts is the desire to protect people from the rigors of market discipline. This is as true for the labor force as it is for the entrepreneurial class. Persistence of inefficient organizations and patterns of resource (both capital and labor) use simply ensure that short-term pain is sacrificed for long-term misery and economic deprivation.” (emphasis added)

Figure 2: DBS Research/Philippine Dealing System: Peso And Remittances Hardly A Correlation To Justify Causality

This should be congruent to the political transition of the Overseas Filipino Workers (OFW), whom once had been reckoned as ‘victims’, and now having accumulated a vote rich constituency via their increased contributions to the economy, is now hailed as “heroes”.

The greatly embellished political role of the OFWs have prompted mainstream media and analysts to even exaggerate on the strength of Peso as having been ‘caused’ by remittances; a causation that isn’t even justified by [tight] correlation, as we have time and again debunked[6] (see figure 2)

Seasonal Patterns Of The Philippine Presidential Cycle Reflects On Fed Bubble Policies

As human beings, we have been hardwired to a pattern seeking behaviour. This apparently has been inherited from our ancestors, whom depended on such instincts so as to deal with the harshness of nature, given the primal era, for survivorship goals.

Despite the notable manifold advances in the realm of science and technology, people resort to the same intuitive approaches today. And this can be observed in many accounts, studies or reports from media or from institutional or academic experts which are fundamentally nothing more than schematics based on pattern searching framework masquerading as analyses. There is this propensity to construct paradigms or models similar to natural sciences, even when conditions are different in the context of social sciences, in order to argue or justify for a possible similarity in the assumed outcome.

I have to say that I am occasionally guilty of this too. For instance, I have made much out of the bullish outcome based on the seasonal performances of the Phisix relative to presidential election cycles which seemed quite compelling as argued here before[7] (see figure 3).

Figure 3: PSE: Presidential Election Cycles

The Philippine stock market has boomed after every election, so far.

On an annualized basis, only 2004 produced the most impressive returns with 26.37% gains. The 1992 and 1998 elections produced an uneventful 9% and 5.3% respectively.

One would notice through the red ellipses in the chart that post election returns were quite significant. This means that the gist of the gains all came in the years following the election, except for 1998 which had a truncated honeymoon.

The easy part is to “rationalize” on the newfound confidence awarded to the new leadership.

But I found such explanation as too facile to be true.

This doesn’t explain the outsized movements of the Phisix during the heydays and this also doesn’t adequately clarify on the fleeting glory of 1998. And importantly, in contrast to the mainstream ideology, asset prices don’t get massively overvalued out of overconfidence or “animal spirits”.

In the basic understanding that shifting bubble cycles are products of government policies then this only means that the essence of bubbles are founded on excessive credit or leverage.

Only waves of speculative money from easy money policies could engender such dramatic movements.

With this in mind, the so-called honeymoon or confidence bestowed to a new leadership is likely to be superficial, coincidental and representative of a secondary effect rather from an ultimate cause.

This type of rationalization, which is often used by media or by surface looking analyst is typically known in the behavioural science as the “available” bias.

Well my suspicion appears to have been given some credible evidence.

We found that in every occasion that the Phisix materially rose in conjunction with the aftermath of Philippine Presidential elections, we discovered that US interest rates have been at the bottom of cycle (see figure 4).

Figure 4: Economagic.com: Fed Fund Rates At Bottom As The Phisix Boomed!

All the blue arrows above have corresponded with the red ellipses in the previous PSE chart.

The explanation is that the low US interest rates, mostly in response to a previous crisis, were meant to provide a cushion on asset prices (except in 1980-1986). This has been popularly known as the Greenspan Put or in the definition of wikipedia.org, ``During this period, when a crisis arose, the Fed came to the rescue by significantly lowering the Fed Funds rate, often resulting in a negative real yield. In essence, the Fed pumped liquidity back into the market to avert further deterioration.” (emphasis added)

The cascading Fed Fund rates of 1980-86 were in reaction to the subsiding inflationary pressures (first arrow). This had been followed by the Black Monday crash in the 19^th of October 1987. Incidentally, Black Monday of 1987 proved to be a baptism of fire for the then newly appointed Federal Reserve Chairman Alan Greenspan (August 1987)

Japan’s property and stock market bubble imploded in 1991 which was nearly concurrent with the US Recession of 1990-1991 triggered by the Savings and Loans crisis (second arrow).

The Asian crisis of 1997 rippled into a Russian financial crisis in 1998. Russia defaulted on her debt and subsequently triggered the Long Term Capital Management (LTCM) crisis. The LTCM crisis was resolved by a rescue from Mr. Greenspan’s US Federal Reserve.

The LTCM episode was further compounded by the concerns over what was deemed as a risk of massive dislocations from the computer and automated adjustments to the new millennium (third arrow).

Finally since bubble after bubble popped around the world (this comprised as the periphery), hot money finally thronged back towards the center or the source of munificent money flows (a.k.a inflation).

And this culminated with the bust of dot.com bubble in 2000 (exacerbated by the 9/11 of 2001), which prompted the Federal Reserve to intensely pare down rates which it held until 2004 (fourth arrow).

Put differently, every time the Philippines held a Presidential election, Fed fund rates were coincidentally were at the maximum state of ‘negative real yields’ from which prompted US based hot money to look for asset markets from which it could push.

And the Phisix bullmarket of 1986-1997 simply accommodated the movements of global hot money flows, which apparently provided a boost to the Presidential honeymoon story which turned out to be more a descriptive narrative than a real causal event.

Yet the lowering of Fed Fund rates in 1998, failed to sustain the rally in the local market because the latter had been afflicted by massive malinvestments from the previous boom, and was yet undergoing a market clearing process which extended until 2003 (if measured from the performance of the Phisix).

As a caveat, I don’t have access to the actual data representing the fluxes of money in and out of the Phisix or in the Philippines, prior to 2003. Nevertheless the Asian crisis was blamed by policymakers on speculative capital or hot money and serves as circumstantial evidence on money flows.

Fortuitously, we find ourselves at the same cycle anew.

But this time, instead of simply the US we have major OECD economies in concert with zero bound policy rates. (see figure 5)

Figure 5: Bank of International Settlements: Low Interest Rates Equals Steep Yield Curve

To quote the BIS, [bold emphasis added]

``Expectations that exceptionally low policy rates would prevail for some time in major developed economies meant that banks and other investors could continue to exploit cheap funding and invest in higher-yielding assets. In fixed income markets, yield curves remained extraordinarily steep, highlighting the potential profit from investing long-term with short-term financing (left-hand panel). The taking of such positions may also have contributed to recent downward pressure on long-term yields. Implied volatilities on interest rate derivatives contracts declined further, suggesting that the perceived risk associated with such investments continued to drop (centre panel).

``The combination of higher returns and lower risk meant that such positions were gaining in attractiveness from a risk-adjusted perspective too. Notably, measures of “carry-to-risk”, which gauges return in relation to a risk measure, reached new highs for this type of position (right-hand panel). Given such incentives, one concern was that financial institutions could be taking on excessive duration risk. Once expectations change and interest rates begin to rise, the unwinding of such speculative positions could reinforce repricing in fixed income markets and result in yield volatility.”

As you would note, the record steep yield curves, by artificially lowering of the interest rates, provides a very compelling incentive to get cheap financing over the short term in order to profit from investing or speculating on the long term high yielding assets.

And forcing down rates has created an impression of a stable environment conducive to risk taking.

Essentially you have the seeds of a global bubble in place. Next is to see financial institutions (private or even government institutions) taking on more leverage and this means bidding up asset prices.

Carry trades that arbitrages OECD currencies to invest in high yielding emerging markets like the Philippine Stock Exchange (PSE) or commodities will likely intensify, and other forms of vehicles for leveraging could surface.

Nevertheless, the inflationary bias by global policymakers are very very clear. And this reflects on the revolting fear by central bankers on the prospects of deflation.

As Frederick Hayek once wrote[8], ``the chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable. But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation." [emphasis added]

Summary and Conclusion

In summary, we don’t expect to see any material changes in the Philippine political economy emanating from a change in leadership from the upcoming elections. It’s more about a change of guards than from an overhaul of a system that will still be dominated by the same patronage-rent seeking politics.

Hence, markets are not likely to also reflect on uncertainties by a new face at Malacañang, unless an underdog outside the sphere of candidates among political elites surprises the public.

What would matter more will be the political reactions by the new stewards to the growing influence of external forces. We expect political trends to increasingly be shaped by the free trade zone recently established with our neighbours and with China, aside from the growing foreign policy influence of China in Asia, at the expense of the US.

Finally, it is more likely that zero bound OECD monetary policies will provide traction to the domestic market action than from the results of election. The steep yield curve, from artificially reduced rates induces the public to undertake speculative and encourages international carry trade or currency arbitrages. Such dynamic should underpin the activities in the Philippine Stock Exchange.

One must be reminded that due to the morbid fear of policymakers of deflation, they have inexorably taken an inflationary bias that punishes savers. This is likely to fuel bubble cycles in several parts of the world.

To my mind, the Phisix seems likely a candidate.

---

[1] see Philippine Election Myth: "I Am Not A Thief!"

[2] See Popularity Based Politics Equals Waking Up To Frustration

[3] See Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone

[4] "It is a mistake to assume that as long as such conceptions prevail any endeavors to lower the obstacles to international trade could be successful. If the theories in favor of protection and self-sufficiency are considered as right, then there is no reason to bring down trade barriers; only the conviction that these theories are wrong and that free trade is the best policy can shake them. It is inconsistent to support a policy of low trade barriers. Either trade barriers are useful, then they cannot be high enough; or they are harmful, then they have to disappear completely". see von Mises, Ludwig, The Disintegration of the International Division of Labor, Money, Method, and the Market Process, Chapter 9

[5] Boettke Peter, An Austrian Economist Perspective on Transitional Political Economy

[6] See How The Surging Philippine Peso Reflects On Global Inflationism

[7] see Focusing On The Future: the Phisix and the Philippine Presidential Cycle

[8] Boettke, Peter Reading Hayek -- Or Why I Think Monetary Policy Based on Monetary Equilibrium Theory Might Run Into Problems in a World of Central Banking

A Gallery of Obsolete Occupations

A wonderful showcase of jobs lost due to technological evolution from NPR.com.

A sample with a description shown below (click on the image to redirect to NPR.)[thanks to Cafe Hayek]



This serves as a reminder of how advances in technology induces material changes in the economy. It's an inevitable trend.

Competitive Global Tax Structures As Major Investment Determinant

When you read economic articles from the mainstream media or from popular "experts", one would accrue two significant but misleading impressions:

1. governments are the sole entities that are engaged in trade (from discussions of trade imbalances)

2. low wages are the only criteria that ensures success or economic prosperity (from discussions of currency manipulation)

But of course, such discussions is far from the truth or reality.

Governments generally don't produce anything but generates its revenues by taxation. This means that people through various forms of enterprises, and NOT the government itself, are engaged in trade.

Next, investment is a function of returns: particularly, the rate of return on investments. Of course before establishing the rate of investments, the most important factor would be the return OF investments (via security of property rights).

In other words, expected profits (revenues-costs) determine investment activities.

In contrast to mainstream polemics, the fact is that wages constitute only one of the many variables that adds up to the long list of costs.

Yet there are other factors that determine the profitability of an enterprise among them: as stated above is the varying degree of property rights, different conditions of existing infrastructure, operational institutions, legal framework (which secures contracts and resolves disputes), cultural variables (traditions, superstitions etc.), security, political stability, capital and production structure, access to markets, access to raw materials, access to finance, degree of labor and skills available, education of the labor force, cost of energy, transportation and connectivity, quality of management, regulatory structure, transaction costs, tax policies, degree of economic freedom and etc...

Importantly these cost structures can be nuanced by the operating principles of the comparative advantage and specialization or the division of labor.

Yet all these very important variables are frequently ignored when arguments get oversimplified but cloaked with technical gobbledygook.

Below is an example of a more important factor that influences business activities.

It's about tax structures.

The chart taken from the Economist, highlights on the world's declining corporate tax rates.

The Economist with a tinge of demur from falling tax rates writes, (bold highlights mine)

``CORPORATE-TAX rates in OECD countries have fallen remorselessly over the past 30 years. A survey by Robert Carroll of American University in Washington, DC, found that the top rate in OECD countries (excluding America) had dropped from 51% in the early 1980s to 32% by 2009. Competition among countries to attract business and with it bring employment was fierce in the late 1990s and early 2000s. Ireland reduced its corporate-tax rate to just 12.5% and chose not to raise it last year during an emergency budget. Such differentials may not last long. High-tax European governments have complained in the past about competition from countries such as Ireland and the current economic crisis may lead to more calls for co-ordination of tax policies."

Of course, coordination of tax policies won't work. Competition among governments will still determine investments.

This from World Bank's Paying Taxes 2010

According to Doing Business 2010 (all bold and italics emphasis mine)

``The size of the tax burden on businesses matters for investment and growth. Where taxes are high and corresponding gains seem low, the incentive for businesses to opt out of the formal sector increases.

``A recent study shows that higher tax rates are associated with lower private investment and fewer formal businesses. A 10 percentage point increase in the effective corporate tax rate is associated with a reduction in the ratio of investment to GDP of up to two percentage points and a decrease in the business entry rate of about one percentage point. Other research suggests that a one percentage point increase in the statutory corporate tax rate would reduce the local profits of existing investments by 1.31 percentage points on average and lead to an 18 percentage point increase in average debt-to-asset ratios (part of the reason for the lower reported profits). A one percentage point increase in effective corporate tax rates reduces the likelihood of establishing a subsidiary in an economy by 2.9 percentage points.

``Besides the taxes paid, there are costs of complying with tax laws and of running the revenue authority. Worldwide on average, a standard small to medium sized business still spends three working days a month complying with tax obligations as measured by Doing Business. Where tax compliance imposes heavy burdens of cost and time, it can create a disincentive to investment and encourage informality. Particularly in developing economies, large informal sectors contribute to the creation of an uneven playing field for formal small and medium sized enterprises, squeezed between smaller informal competitors and larger competitors whose greater resources can help win a more effective audience with government and thus greater tax concessions."

``Worldwide, economies that make paying taxes easy tend to focus on lower tax rates accompanied by wider tax bases, simpler and more efficient tax administration and one tax per tax base. They also tend to provide electronic filing and payment systems, which reduce the tax burden for firms while lightening their administrative requirements."

So as the multilateral government institution World Bank points out, tax rates juxtaposed with tax and regulatory compliance plays a major role in the shaping of trade balances among nations and in domestic economic development.

The sub-Saharan Africa has the highest tax rates around the world along with dubious recognition for property rights and mired with political instability ,which offsets its lowest wage framework, hence remains the least attractive venue for investors which has stagnated their economies.

On the other hand, the reasons why Asia and many Emerging Markets has been generating increasing investments is due to the relative advantage of their tax structures.

As we said above competition among governments will ascertain the flow of investments and the recent bubble bust just drove a wedge between responsible and profligate governments.

To wit, the responses by the OECD governments to the recent bubble bust is likely to amplify these differences: higher taxes-lower return for OECD economies as against lower taxes-higher return for Asia and emerging markets.

Guess where investments will flow to?

Seth Klarman's Forgotten Lessons of 2008

Interesting insights from market guru Seth Klarman, courtesy of My Investing Notebook

(all bold highlights mine), [my comments]

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

``One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

``Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

[In a world of fiat money, one must realize that bubble cycles are its main feature. It's all a matter of understanding and timing the cycles]

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

[Bubble mechanism is generally a feedback loop between prices and collateral values]

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

["Risk comes from not knowing what you are doing" or "the dumbest reason in the world to buy a stock is because it's going up" to quote Warren Buffett.]

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

[models function as scientific rationalizations to peddle unrealistic premises]

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

[For a value investor-yes, averaging down is a commendable approach, but for traders the play is different]

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

[the danger from financial innovation stems from elite political entities gaming the system]

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

[rating agencies are part of the network of political enterprises]

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

[leverage is the fuel of all bubbles]

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank's management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

[Amen!!!!]

18. When a government official says a problem has been "contained," pay no attention.

19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

[except for leverage speculators, all the rest compose of the political networks]

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

[I'd like to add: "Blue chips" are risk free!]

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

[digging and filling holes on the ground as proposed by the mainstream will]

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

[not unless taxpayers shoulder the losses]

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

[this called confirmation bias]

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost.

[this is a fairy tale relied upon by the government and the mainstream]

(Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)-[Indeed!!!]

Global CDS Update: World Credit Stress Easing

Here's an update on the world Credit Default Swap (CDS) market from Bespoke Invest.

Based on the Feb 5 lows, as Bespoke observes, ``Portugal default risk is down the most at 40%, followed by Austria (-38%), and Spain (-32%). Vietnam, Argentina, and Egypt are the only countries that have seen default risk increase.

While most of the CDS have been significantly down from the early February anxiety, they are mostly up compared to the start of 2008 except for Lebanon and Kazakhstan.

Such easing of credit concerns adds to our "sweet spot" scenario.

Peak Oil: Where Art Thou?

Unrecognized by many, technology has significantly been improving on the way we do things. This includes finding new and adding to the existing resources that are deemed useful to society.

The chart found below is an example.

True, while oil prices are currently hovering at $80, technology is fast catching up on how unconventional oil is being found.
According to the Economist, (bold highlights mine)

``BP, A big British oil company, announced a round of efficiency measures and cost cuts on Tuesday March 2nd aimed at increasing annual profits by $3 billion over the next few of years. But BP and the world's other big oil companies face similar problems when it comes to boosting profits. Few big new oil fields that are easy to reach and cheap to exploit have been discovered in recent years. This has driven firms to seek oil ever deeper below the sea. In 1947, Kerr-McGee built the world’s first offshore oil well that was completely out of sight of land, drilling 4.6 metres into the seabed off the coast of Louisiana. This year Shell's 22,000-tonne Perdido rig is set to begin operation. Standing nearly as tall as the Eiffel Tower, it is chained to the seabed 2.4km metres below and is capable of extracting oil at a maximum depth of 2.9km."

I'd propose that the problem of high oil prices isn't due to the "perceived" scarcity of oil (or peak oil), but instead with over 90% of proven oil reserves held by governments, the problem is one of the access to these reserves as shown below.

Chart from the US EIA

In short, while government intervention adds to the inaccessibility factor in the supply side, government inflationism (too much printing money, subsidies, etc...) has been prompting for artificially increased demand, which compounds on the market distortions which results to high (and prospectively higher) oil prices.

To consider, technology has materially improved, in spite of the tremendous restrictions and contortions plaguing the oil marketplace.

Had free markets been allowed to function, we'd likely see the wonders of the price mechanism work by having more supplies sooner than later. In addition, markets are likely to discover feasible oil substitutes rather than government imposed options via subsidies.

As Professor Don Boudreaux explains, (bold highlights mine)

``Petroleum was no resource to our ancestors who had yet to grasp the fact that it can be refined and burned in ways that improve the quality of life. In fact, I suspect that whenever that gooey, noxious black stuff appeared in freshwater creeks in pre-Columbian Pennsylvania, natives of that region regarded it as a nuisance.

``So economically, the Earth's supply of nonrenewable energy resources was, back then, much smaller than it is today. Human creativity and effort turned a nuisance into a resource.

``Human creativity and effort also are at work finding not only substitutes for oil, but also new supplies of oil. Each success on this front increases the supply of oil. The reason is that oil deposits that remain unknown are economically nonexistent.

``The same is true of oil deposits that are known to exist but are currently too costly to tap. Oil in the Earth's crust that is out of reach with existing technology is no more of a resource today than is oil on Pluto. But if and when human creativity discovers cost-effective techniques for extracting that oil, it then -- and only then -- becomes a resource. In effect, more of the resource "oil" is created.

``Of course, as a matter of physics, there is indeed only a finite amount of oil in the Earth. But we have no idea how much. And our ignorance of this physical fact is economically relevant."

In short, access to resources is a function of how the market values them, which can only be determined by the price mechanism.

Quality Of Corporate Management As Barrier To Low Wage Competition

Another main reason why the meme of "low wages abroad steal local jobs" is rubbish- is because of the varying quality of management in different types of companies in different nations.

Stanford's Nicolas Bloom and John Van Reenen in their paper "Why Do Management Practices Differ across Firms and Countries?" enumerates why: (all bold highlights mine) [HT: Econlog]

First, firms with “better” management practices tend to have better performance on a wide range of dimensions: they are larger, more productive, grow faster, and have higher survival rates.

Second, management practices vary tremendously across firms and countries. Most of the difference in the average management score of a country is due to the size of the “long tail” of very badly managed firms. For example, relatively few U.S. firms are very badly managed, while Brazil and India have many firms in that category.

Third, countries and firms specialize in different styles of management. For example, American firms score much higher than Swedish firms in incentives but are worse than Swedish firms in monitoring.

Fourth, strong product market competition appears to boost average management practices through a combination of eliminating the tail of badly managed firms and pushing incumbents to improve their practices.

Fifth, multinationals are generally well managed in every country. They also transplant their management styles abroad. For example, U.S. multinationals located in the United Kingdom are better at incentives and worse at monitoring than Swedish multinationals in the United Kingdom.

Sixth, firms that export (but do not produce) overseas are better-managed than domestic non-exporters, but are worse-managed than multinationals.

Seventh, inherited family-owned firms who appoint a family member (especially the eldest son) as chief executive officer are very badly managed on average.

Eight, government-owned firms are typically managed extremely badly. Firms with publicly quoted share prices or owned by private-equity firms are typically well managed.

Ninth, firms that more intensively use human capital, as measured by more educated workers, tend to have much better management practices.

Tenth, at the country level, a relatively light touch in labor market regulation is associated with better use of incentives by management.

My comment:

In short, there isn't a single type of management, as much as there is no single class of product or markets or labor or capital.

In the above chart, the US ranks the highest so as with other export giants.

So it would be fallacious and oversimplistic to generalize that investments are only sensitive to the cost of wages, when there are myriads of variables affecting investments.

From Noble To Cruel Intentions: The Chemist's War of Prohibition

This article from Slate Magazine is a lurid example of how government policies that are initially meant to attain noble goals turn up as violating human right to life and liberty. (hat tip: Cafe Hayek)

As the Chicago Tribune editorial quoted by article in 1927, ``It is only in the curious fanaticism of Prohibition that any means, however barbarous, are considered justified."

Some excerpts... (bold emphasis mine)

``Frustrated that people continued to consume so much alcohol even after it was banned, federal officials had decided to try a different kind of enforcement. They ordered the poisoning of industrial alcohols manufactured in the United States, products regularly stolen by bootleggers and resold as drinkable spirits. The idea was to scare people into giving up illicit drinking. Instead, by the time Prohibition ended in 1933, the federal poisoning program, by some estimates, had killed at least 10,000 people.

``Although mostly forgotten today, the "chemist's war of Prohibition" remains one of the strangest and most deadly decisions in American law-enforcement history. As one of its most outspoken opponents, Charles Norris, the chief medical examiner of New York City during the 1920s, liked to say, it was "our national experiment in extermination."

The origins...

``The saga began with ratification of the 18th Amendment, which banned the manufacture, sale, or transportation of alcoholic beverages in the United States.* High-minded crusaders and anti-alcohol organizations had helped push the amendment through in 1919, playing on fears of moral decay in a country just emerging from war. The Volstead Act, spelling out the rules for enforcement, passed shortly later, and Prohibition itself went into effect on Jan. 1, 1920.

The unintended consequences...

``But people continued to drink—and in large quantities. Alcoholism rates soared during the 1920s; insurance companies charted the increase at more than 300 more percent. Speakeasies promptly opened for business. By the decade's end, some 30,000 existed in New York City alone. Street gangs grew into bootlegging empires built on smuggling, stealing, and manufacturing illegal alcohol. The country's defiant response to the new laws shocked those who sincerely (and naively) believed that the amendment would usher in a new era of upright behavior."

The circumvention of laws, the counter policies and the aftermath....

``Rigorous enforcement had managed to slow the smuggling of alcohol from Canada and other countries. But crime syndicates responded by stealing massive quantities of industrial alcohol—used in paints and solvents, fuels and medical supplies—and redistilling it to make it potable.

"Well, sort of. Industrial alcohol is basically grain alcohol with some unpleasant chemicals mixed in to render it undrinkable. The U.S. government started requiring this "denaturing" process in 1906 for manufacturers who wanted to avoid the taxes levied on potable spirits. The U.S. Treasury Department, charged with overseeing alcohol enforcement, estimated that by the mid-1920s, some 60 million gallons of industrial alcohol were stolen annually to supply the country's drinkers. In response, in 1926, President Calvin Coolidge's government decided to turn to chemistry as an enforcement tool. Some 70 denaturing formulas existed by the 1920s. Most simply added poisonous methyl alcohol into the mix. Others used bitter-tasting compounds that were less lethal, designed to make the alcohol taste so awful that it became undrinkable.

``To sell the stolen industrial alcohol, the liquor syndicates employed chemists to "renature" the products, returning them to a drinkable state. The bootleggers paid their chemists a lot more than the government did, and they excelled at their job. Stolen and redistilled alcohol became the primary source of liquor in the country. So federal officials ordered manufacturers to make their products far more deadly."

Gruesome.

Read the rest of the article here

As self-development author Robert Ringer rightly argues, ``just because government mandates something to be right or wrong doesn’t mean that it is right or wrong. If a government mandate calls for the violation of even one individual’s sovereignty, it is wrong in the eyes of Natural Law — or what can also be referred to as the Law of Non-aggression. Aggression is always the sacred measuring stick of right and wrong — period."

Global Stock Market Update

Bespoke Invest provides an update of global markets from two perspective: advance from the recent February 8 lows and a year to-date performance.
According to Bespoke:

``Sixty-five out of the 81 country indices listed below are up since the markets made their recent correction lows on February 8th. As shown, Greece (the country causing everyone to get all worked up recently) is up the second most of any country shown since 2/8 with a gain of 11.92%. The Ukraine is up the most with a gain of 12.69%. Brazil has been the best performing BRIC country with a gain of 7.88%. Five of the seven G7 countries are doing better than three of the four BRIC countries since the recent lows. Britain, Canada, the US, France, and Germany are all up more than Russia, India, and China during the most recent rally. For the year, 44 out of 81 countries are in positive territory, with Estonia, Ukraine, and Bangladesh leading the way. The US is outperforming all four BRIC countries so far in 2010. Slovakia, Dubai, and Spain have been the worst performing countries this year, all with declines of more than 10%."

I'd like to add that while indeed the G7 has generally outclassed the BRIC and major emerging markets, I wouldn't count on this phenomenon to last.

Second, it is noteworthy to see the Philippines stage a strong comeback from the recent lows and place among the top ten. I'd be more comfortable to see our neighbors close the gap.

Lastly despite brouhaha over Greece, as pointed out by Bespoke, she is the second best performer since the Feb low but still down for the year. One would note that the Baltic states which had been slammed hard at the height of the crisis, has now outperformed the world for the year. We can't underestimate similar performances from the PIIGS as the crisis breezes over. But again, every nation have their own quirks.

John Law, Paper Money and the Mississippi Bubble

Another very informative stuff from Mises Blog (Jeffrey Tucker).

This cartoon video shows of John Law's experiment with paper money that sparked the Mississippi bubble.

History indeed rhymes.

Econ 101: Prices, Profits, and Resource Misallocations From Interventionism

This short but insightful documentary video from Mises Blog shows of the basic functionality of profits to society- in contrast to the evil portrayal by the mainstream and politicians.