Rationalizing the Record Phisix 7,700

If you look at the typical stock on the New York Stock Exchange, its high will be, perhaps, for the last 12 months will be 150 percent of its low so they’re bobbing all over the place. All you have to do is sit there and wait until something is really attractive that you understand. And you can forget about everything else. That is a wonderful game to play in. There’s almost nothing where the game is stacked in your favor like the stock market. What happens is people start listening to everybody talk on television or whatever it may be or read the paper, and they take what is a fundamental advantage and turn it into a disadvantage. There’s no easier game than stocks. You have to be sure you don’t play it too often. You need the discipline to say no. –Warren Buffett

In this issue:

Rationalizing the Record Phisix 7,700

-False Investment Flows and Blind Confidence

-Marking the Close as Confidence Booster?

-Record Phisix 7,700 Equals Overtrading!

-Phisix 7,700: BSP Chief Express Concerns Over External Forces

-China’s PBOC and Danish Central Bank Panics!

Rationalizing the Record Phisix 7,700

This week Phisix broke through the 7,700 levels. Record after record.

False Investment Flows and Blind Confidence?

The PSE’s press release on the ninth record streak (bold mine): Year-to-date, the PSEi has broken through new record highs 9 times. It has also posted a 6.9 percent gain since the start of the year. "We are pleased with the market's movement in the last five weeks. The record numbers registered by the index highlights the level of investor confidence in our market. We hope that our initiatives to raise awareness about investing at the PSE to fund managers here and abroad will see more investment inflows into our market," PSE President and CEO Hans B. Sicat said.

First of all, the fact is that there is NO such thing as investment flows. For every buyer of a security there is a matching seller, the matching is expressed via peso (buy) per peso (sell) trades. What changes is the composition of the stock market ownership. For instance if foreign funds are buying, then the sellers would be local entities and vice versa.

This is not meant to nitpick on the PSE but to show how real exchanges work.

What record prices have been indicating instead has been the degree of aggressiveness of buyers to bid up prices relative to sellers.

It’s not about flows.

Over the past 5 weeks, there has been an “improvement” in foreign participation, but this has mostly been from special block sales of FGEN (January 21), JGS (January 22) and GTCAP (February 3)

Yet the PSE has not clearly stated why record after record stock levels should highlight as foreign investment attraction. 

The year to date performance accompanied by the PER ratio of the entire Phisix basket demonstrates how the Phisix has reached the current levels. The arrangement in the chart has been ranked according to market weightings as of February 6 close.

The green rounded rectangle on the left reveals of the quality and quantitative aspects of 7,700

There have been 12 stocks (with 6% and above) that have buoyed the Phisix while the rest has been underperforming the bellwether. Remember the Phisix has posted 6.9% returns year to date.

The above implies that the pump and push has not only been in the most popular trades but on the biggest market caps! In short, these stocks have been mostly responsible for Phisix 7,700. The concentration of pump on the biggest market caps, which has been a continuation of the trend from 2014, has led to nose bleed PERs (see right boxes).

Basically the top 15 issues have PERs at celestial levels, ranging from 18 to 50!

Let me cite an example. Consumer stock URC declared that for 2014, profit growth came at 15.2%. In 2014, URC’s stock price generated 73.3%. This means that markets paid a shocking premium of 4.82% for every 1% earnings growth. Such pump has led to URC’s PER to 40+ (45.87 as of February 5 based on PSE data)!

As a side note, the reason I chose URC is because I just came across their first quarter performance (last quarter 2014) 12.6% performance.

Let us do some back of the envelop calculations and grant the past will project into the future where 2014 will repeat in toto this year.

At the end of year, URC’s stock price will be at 340 (196 * 73.3%) while EPS will jump from (Thursday’s close 204/ PER 45.87) 4.45 to 5.13 or 15.2% earnings growth. This implies PE at 66.28!

Such level of valuations will become an attraction for foreign investors? Perhaps for Wall Street high rollers or momentum traders financed by carry trades, but not serious fund managers.

As shown in the above, all these have nothing to do G-R-O-W-T-H, but about speculative orgies founded on the catchphrase of G-R-O-W-T-H. Domestic punters have become like Pavlov’s dogs, conditioned to pump and push at every citation of G-R-O-W-T-H. But instead of dogs drooling in the sound of ringing of the bells, when media, politicians and experts utter G-R-O-W-T-H, punters go into a blind hysteric bidding spree! Risk and valuations have been thrown under the bus!

Yet how much of these bidding orgies have been financed by debt?

Marking the Close as Confidence Booster?

Third, it doesn’t seem that 7,700 Phisix has been all about the “level of investor confidence”.

Record 7,700 Phisix as noted above has been about concentration of pumps on popular and biggest market cap stocks. The Phisix year to date performance can be squared with the “marking the close” activities or attempts at managing the index. 

“Marking the close” is supposed to be a violation of the Philippine Securities Code but yet such practice has become rampant.

Record 7,700 Phisix has now been seen as a ONE way street. Corrections are simply not tolerated. Last week’s major marking the close has been used during corrections.

Last Monday February 2 (see left pane), the Phisix fell by as much 99 points or by 1.3% but the index managers ensured that losses will have to be mitigated. So the last minute pump resulted to the Phisix down by only 59.2 point or by .77% or .53% of the losses evaporated from a manic buying spree at the last minute. (charts above from technistock and colfinancial)

The same has been applied to the session on February 5, where marking the close reduced losses to just .54% (see middle). A minor “marking the close” became part of 7,700.

The serial “Marking the closes” has created a false perception of level of confidence. What it has really done has been to contribute to the ludicrous mangling of the pricing discovery system that has spawned outrageous mispricing of domestic securities.

As I have been saying the higher the Phisix, the greater the risks. This means that instead of sound market dynamics, Phisix 7,700 signifies a symptom of progressing financial instability.

Yet I am not sure that foreigners will see attractiveness in markets that have been gamed.

Record Phisix 7,700 Equals Overtrading!

The “I belong to the mainstream” crowd claims that the peso volume has been “heavy”. The claim is meant to justify the pump by appealing to the majority. Yet “heavy” really depends on data or reference points of comparison.

On an absolute level this has hardly been true or PSE data suggests the contrary. While peso volume (averaged on a daily basis) has been rising, peso volume remains off from the May 2013 levels. So far, current levels have reached the taper tantrum selloff volumes. And a significant chunk of current volume has been helped by huge special block sales.

What has really been a standout has been the number of daily trades. Trade churning has bloated by an astounding 50% from 2013 highs. The swelling of trade churning perhaps has likely been less about the growth of retail trades but more about, as I suspect, the managing of the index.

Historically, overtrading has been symptoms of a market top or market inflection points. Historian Charles Kindleberger sees overtrading as a symptom of a progressing “mania” where he noted[1],

The result of the continuation of the process is what Adam Smith and his contemporaries called ‘overtrading.’ This term is less than precise and includes speculation about increases in the prices of assets or commodities, an overestimate of prospective returns, or ‘excessive leverage.’ Speculation involves buying commodities for the capital gain from anticipated increases in their prices rather than for their use. Similarly speculation involves buying securities for resale rather than for investment income attached to these commodities. The euphoria leads to an increase in the optimism about the rate of economic growth and about the rate of increase in corporate profits and affects firms engaged in production and distribution

And how asset inflation tends to camouflage imbalances…

Even though bank loans are increasing, the leverage—the ratio of debt to capital or to equity—of many of their borrowers may decline because the increase in the prices of the real estate or securities means that the net worth of the borrowers may be increasing at a rapid rate.

And how asset inflation incites a bandwagon effect applied to social status and the credit system…

A follow-the-leader process develops as firms and households see that others are profiting from speculative purchases. ‘There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.’ Unless it is to see a nonfriend get rich. Similarly banks may increase their loans to various groups of borrowers because they are reluctant to lose market share to other lenders which are increasing their loans at a more rapid rate. More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return. Making money never seemed easier. Speculation for capital gains leads away from normal, rational behavior to what has been described as a ‘mania’ or a ‘bubble.’

Phisix 7,700: BSP Chief Express Concerns Over External Forces

And yet while officials of the PSE have been patting their backs on the record after record levels, the Bangko Sentral ng Pilipinas honcho, Amando Tetangco Jr., continues to raise the prospects of risks from the external environment.

In a recent speech he said[2]: (bold mine)

The steep decline in oil prices has complicated the market appreciation of the outlook for monetary policy in 2015.  Some analysts say, the Fed would be hard-pressed to hike rates by any significant measure (as in June this year) if oil prices continue to drop because inflation in the US will be soft.

In addition, low oil prices increase the risk of deflation in the EU and Japan, raising the likelihood that more easing measures would be put in place.

In other words, ladies and gentlemen, whereas markets used to have the confidence in the trend of monetary policies, this new uncertainty from oil price movements is now seen to heighten volatility in financial markets by unsettling investor risk appetite and unseating inflation expectations.

Further, a continued decline in oil price could also change the balance of global growth prospects. There will be winners and losers if low oil prices persist.  While the decline in oil is a dampener to inflation and could raise purchasing power for oil importers, it could also result in a loss of revenues for oil producers and lead to weak aggregate demand. With overall global growth still fragile, the significant drop and the weak prospects in oil prices have gotten more analysts discussing the risk of deflation in recent weeks.

Nonetheless while the BSP chief sanitizes and downplays the risks to the Philippine economy due to the alleged “strong environment”, he sees a potential reemergence of market volatility. 

Also the BSP chief seems to signal the possibility for them to lower interest rates.

Our initial projections using lower oil prices show that inflation would still be within the target range for 2015, which is now lower at 2-4 percent compared to the previous year’s target of 3-5 percent. Indications of easing inflationary pressures owing in part to the decline in international oil prices as well as signs of robust domestic economic growth allow the BSP some room to maintain its current monetary policy stance. Even so, we do not pre-commit to a set course of action. As I have always said, the stance of monetary policy will remain data-dependent.

One thing we keep in the back of our minds is that prices can reverse and often very quickly. If you have been in this market long enough – as I believe some in the audience have – you know that markets tend to get ahead of themselves.  So, we continue to watch developments in the oil market carefully and how these affect inflation and growth dynamics, to see if there is any need to make adjustments in the stance of policy.

Remember what I wrote last week on the 4Q 6.9% GDP[3]?

if the BSP, suddenly cuts rate for one reason or another, say below inflation target, or external based alibis, then this proves that 4Q 6.9% GDP 2014 has all been a Potemkin Village.

In the same speech, the BSP chief denies the risks of deflation, supposedly due to the “ramping up of government spending”, yet this outlook overlooks Japan’s experience.

Following the bursting of the stock market and property bubble, in the 90s Japan’s government engaged into a spending spree but failed to create meaningful growth. Reason? Japan’s economy had been shackled by a mountain of non-performing loans and by a refusal to let the markets clear. Japan’s economy stagnated for decades (continuing until today, hence Abenomics) with CPI prices fluctuating between marginal increases and slight decreases. Such ‘lost decade(s)’ have been misinterpreted by the mainstream as ‘deflation’ when this has been about stagnation.

As a side note, record Phisix 7,700 came as Bank of Japan’s governor Haruhiko Kuroda rang the opening bell for the PSE last Friday. The BoJ’s chief has been the architect of Japan’s incredible divergence, milestone stock market performance in the face of an economic recession! The BoJ’s visit to the Philippines has reportedly been about arranging for peso credit facilities for Japanese companies backed by yen as collateral. With the BoJ so far intent on destroying the yen, the BoJ wants the BSP to accept Japanese collateral with vastly diminishing value. The peso has been climbing against the yen since January of 2012 and has gained 57% as of Friday’s close from the same period. [I understand that currencies may be hedged, what this does is to spread the risks but not to diminish it]. Yet local punters seem to project to BoJ’s Kuroda: if you can do it we can do it! Be careful of what you wish for.

Going back to the BSP, statistics isn’t economics. 

Debt represents the intertemporal distribution of spending activities. Borrowing money to spend simply means the frontloading of spending. The cost of debt financed spending today is spending in the future. Debt will have to be repaid at the expense of future spending. Of course there are productive and non-productive debts. But policies of financial repression via zero bound rates tend to promote non-productive ‘speculative’ and consumption debts.

The BSP fails to understand that having too much debt, which constrains balance sheets, will undermine real economic growth. The transmission mechanism from balance sheet problems will affect prices and subsequently the economic coordination process. The mainstream sees this as lack of aggregate demand when they are in fact balance sheet imbalances. Debt is not a free lunch, not even government debt. McKinsey Quarterly estimates that global debt grew by $57 trillion since 2007 where debt to GDP has reached 286%! Why do you think the negative interest rate policies adapted by many central banks? 

And one only needs to look at the growth conditions of loan and statistical GDP to see how disproportionalities have been mounting in the Philippines.

From end of the year 2008 to end of the year 2014, or in 6 years, production or supply side banking loans has inflated 125% (CAGR 14.51%) whereas gdp (at current prices) has only amassed 70.2% (CAGR 9.3%). The bigger buildup of debt relative to gdp means slower real economic growth ahead. This is regardless whether debt based spending has been due to government or private sector. The government can pump statistical economy but not the real economy.

And since consumer spending accounts for about 70% of the expenditure GDP, HFCE has grown by about a similar rate to statistical gdp of 73.43% (CAGR 9.61%) over the same period.

Yet from the same timeframe, supply side GDP has swelled by outlandish rates as follows: construction 135.1%, trade 105.71%, finance 142.94% and real estate 273.38%. This has been financed mostly by bank credit growth with incredulous growth rates for the said industries at 200.85%, 176.92%, 194.68% and 178.77% respectively. 

So even if Real Estate GDP has ballooned more than the rate of credit growth, the huge disparity between consumer growth and industry growth means severe accumulation of excess capacity in motion. And this will become evident when credit growth slows.

Oh by the way, as possible symptom of excess capacity combined with a slump in retail 4Q GDP—have you seen the dramatic surge in store vacancies in many of the major malls at the metropolis? The vacancy rates of a high end mall have recently soared and appear to have already exceeded 10% of their total retail space! 6.9% 4Q GDP in the face of soaring vacancies in shopping malls! Duh!

And I’m not sure if the BSP chief has merely been just parroting what the central bank of central banks, the Bank for International Settlement has been saying, or if he is just underwriting an escape clause to exonerate (him and the BSP) when risks transforms into reality, nevertheless, the concerns of the BSP chief (or by the BSP) seem at material odds with the heady outlook of PSE officials.

Statistics isn’t economics. What seems as may not be what’s real. Notice how “strong” statistics have often been masked by an inflation boom as indicated by historian Charles Kindleberger? Warren Buffett’s alternative axiom has been: Only when the tide goes out do you discover whose swimming naked.

Two recent examples of “swimming naked” exposed.

Remember Brazilian tycoon Eike Batista whose worth was once quoted as anywhere from $25 to $35 billion in 2012 and was named as the 8th richest man in the world by Forbes Magazine in 2011? Well he is now a “negative” billionaire. Now, Mr. Batista reportedly owes $1.2 billion. Thus authorities have been seizing his assets, which includes white Lamborghini and $32,490 in cash, computers, and watches — as well as any real estate, six other cars, his boat and his airplanes, according to the Businessinsider.com

Worst, compounding his financial woes, the erstwhile mining and oil tycoon has now been faced with charges of insider trading and stock market manipulation.

Mr. Batista’s financial crash took only less than two years to happen. Who would have thought that billions worth of wealth (paper) can vaporize so fast? And yet when revulsion and discredit sets in, the blaming part begins.

At the turn of the business cycle, I believe that there will many miniature Eike Batistas, here and abroad.

For the domestic setting, I predict that “when the tide goes out”, the serial “marking the closes” will likely become a future legal issue.

Next, another account of what seems as, may not really be: Brazil’s state firm Petrobas

From Bloomberg: (bold mine) When Brazil emerged from the global financial crisis as one of the world’s great rising powers, Petrobras was the symbol of that growing economic might. The state-run oil giant was embarking on a $220 billion investment plan to develop the largest offshore crude discovery in the Western hemisphere since 1976 and was, in the words of then-President Luiz Inacio Lula da Silva, the face of “the new Brazil.” Today the company epitomizes everything that is wrong with a Brazilian economy that has been sputtering for the better part of four years: It’s mired in a corruption scandal that cost the CEO her job this week; it has failed to meet growth targets year after year; and it’s saddling investors with spectacular losses. Once worth $310 billion at its peak in 2008, a valuation that made it the world’s fifth-largest company, Petroleo Brasileiro SA is today worth just $48 billion.

The face of “New Brazil”—another slogan highlighting euphoric “this time is different” demolished!

Rings a bell?

China’s PBOC and Danish Central Bank Panics!

Two central banks seem as in a panic mode. 

In Denmark, the Danish Central Bank cut interest rates by another 25 basis points which brings Danish interest rates deeply into negative territory -.75. This marks the fourth cut in less than 3 weeks intended to defend the Danish krone-euro peg which has reportedly been under heavy assault from speculators. Will the krone-euro peg break soon? Will there be a huge demand for cash too…reinforcing deflation?

China’s PBoC seems to have panicked too. The PBoC suddenly cut reserve requirements in the wake of a slower than expected bank lending, an unexpected contraction of factory activities and a slowdown in the service industry.

Government economists as quoted by media say that the cut, which injects $96 billion to the economy, has been aimed at curtailing the yuan’s slide as a result of accelerating capital outflows. Capital flight hit a record $91.2 billion in the fourth quarter according to a report from Bloomberg. The said report also noted that PBoC injected $31 billion over the past three weeks. 

If cutting reserves had been intended to defend the yuan then this will hardly work.

First some data. Chinese credit to GDP has been reported by McKinsey Quarterly at 282% as of 2Q 2014. Corporate debt has been estimated by McKinsey at 125% of GDP the highest level in the world! In addition, Chinese debt has been concentrated to the real estate sector, along with a massive growth in Shadow Banking and in local government debt.

Given the sustained downturn in housing prices, which continues to put pressure on the economy and on credit conditions, capital flight would be a natural response for investors and currency holders anticipating a far worse outcome.

Cutting reserve requirements would free up resources for banks to lend but this will hardly attract credit activities if the balance sheets of Chinese residents and companies have been hocked to the eyeballs with debt.

Given the above statistics, what happens instead will be more access to credit in order to pay off existing loans (debt rollover) rather than for investment. The end result of the ‘extend and pretend’ strategy will be to increase debt levels as GDP cascades.

The Chinese government seems in a bind to desperately defer the inevitable distressing adjustments.

Interestingly, Hong Kong’s tourism seems as suffering from a facelift. Chinese tourists have become dominated by ‘Day Trippers’ which now accounts for a record 60%of Chinese tourists. According to a report from Bloomberg, Day-trippers spent an average of around HK$2,700 ($350) per capita in Hong Kong in 2013, compared with about HK$8,800 by overnight tourists, according to government data.

Wow, that’s a 69% collapse in spending budget by tourists! And this has resulted to a slump in luxury brand sales but a surge in medicine and cosmetic sales! What the report suggests has been that China’s economic slowdown and the government’s anti-corruption drive (political persecution) have changed the character of Hong Kong based Chinese tourists.

Well if the trend continues, then this will radically shake up the Hong Kong economy!

Now the report also says that the wealthy have been shifting visits to Japan, South Korea and Taiwan, but they didn’t give the numbers.

Anyway, Hong Kong’s dilemma seems to have been shared by the miseries of Macau as expressed by the crashing share prices and earnings of casinos. 

And applied to the Philippines, if those wealthy Chinese high rollers don’t come streaming into the Philippine casinos soon, excess capacity will lead to losses and subsequently credit troubles.

The effects of the looming shortage of Chinese gamblers will not be isolated to casinos but will extend to creditors, suppliers and workers of the industry. The chain reaction will spread to the economy. If you add other risks areas like shopping mall or other property related industries the direct and indirect effects will be magnified.

In addition, a radical makeover of the Hong Kong’s economy may jeopardize domestic OFWs working there.

But then, according to the record Phisix 7,700 risks and valuations have all been expunged out of existence! Stocks and economic conditions are a one way street! So for the mainstream, we should not only buy, buy, buy!...but also borrow borrow borrow to buy, buy, buy! Money’s free!

---

[1] Charles Kindleberger, Manias, Panics, and Crashes A History of Financial Crises Fifth Edition, Now and Futures

[2] Amando M. Tetangco Jr. Working Together towards a Stronger Economy January 30, 2014 Bangko Sentral ng Pilipinas

[3] See Phisix: Philippine 4Q 6.9% GDP: A Story of Government Pump and Mounting Excesses February 2, 2014

The Agency Problem: The Difference between an Investment Firm and a Marketing Firm

Wall Street Journal's business columnist Jason Zweig frames the agency problem in a remarkably different light: the fiduciary duty of finance managers.

Excerpted from Mr. Zweig’s excellent speech entitled “Putting Investors First”, as published at his website (hat tip Tim Price) [bold mine]

How do a marketing firm and an investment firm differ?  Let us count the ways:

-The marketing firm has a mad scientists’ lab to “incubate” new funds and kill them if they don’t work.  The investment firm does not.

-The marketing firm charges a flat management fee, no matter how large its funds grow, and it keeps its expenses unacceptably high.  The investment firm does not.

-The marketing firm refuses to close its funds to new investors no matter how large and unwieldy they get.  The investment firm does not. 

-The marketing firm hypes the track records of its tiniest funds, even though it knows their returns will shrink as the funds grow.  The investment firm does not.

-The marketing firm creates new funds because they will sell, rather than because they are good investments.  The investment firm does not.

-The marketing firm promotes its bond funds on their yield, it flashes “NUMBER ONE” for some time period in all its stock fund ads, and it uses mountain charts as steep as the Alps in all its promotional material.  The investment firm does none of those things.

-The marketing firm pays its portfolio managers on the basis not just of their investment performance but also the assets and cash flow of the funds.  The investment firm does not.

-The marketing firm is eager for its existing customers to pay any price, and bear any burden, so that an infinite number of new customers can be rounded up through the so-called mutual fund supermarkets.  The investment firm sets limits.

-The marketing firm does little or nothing to warn its clients that markets do not always go up, that past performance is almost meaningless, and that the markets are riskiest precisely when they seem to be the safest.  The investment firm tells its customers these things over and over and over again.

-The marketing firm simply wants to git while the gittin’ is good.  The investment firm asks, “What would happen to every aspect of our operations if the markets fell by 67% tomorrow, and what would we do about it?  What plans do we need in place to survive it?”

Thus you must choose.  You can be mostly a marketing firm, or you can be mostly an investment firm.  But you cannot serve both masters at the same time.  Whatever you give to the one priority, you must take away from the other.

The fund industry is a fiduciary business; I recognize that that’s a two-part term.  Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits.  And that’s as it should be.  In the long run, however, you cannot  survive as a business unless you are a fiduciary emphatically first.

In the short term, it pays off to be primarily a marketing firm, not an investment firm.  But in the long term, that’s no way to build a great business.  Today, tomorrow, and forever, the right question to ask yourselves is not “Will this sell?” but rather “Should we be selling this?”  I will praise every fund company that makes that choice based on what is right for its investors, because I believe that standard of judgment is the right standard.

Amen.

But don’t expect the fiduciary role to be adapted by the sellside industry who predominantly embraces the "marketing" aspect as their core function. That's because most of them seem as adherents to JM Keynes' sound banker principle:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

Quote of the Day: The Scarcest Ability Among Economist is Good Judgment

I am thinking that you may well share my view, which I have held for a very long time, that the scarcest ability among economists (and others who purport to have expertise about economic matters) is good judgment. Many economists are obviously very smart, in the sense that they are good at math and can wheel and deal with pretty complex mathematical models and econometric exercises. But this sort of technical ability may — and sad to say, usually does — have little or nothing to do with actually understanding how the world works. What I call good judgment about economic reality seems to depend much more heavily on a combination of (1) mastery of basic applied price theory, the theory of how changes in incentives and relative costs affect actions taken at the margin(s); (2) substantial knowledge of economic history and the institutional context of economic actions; and (3) a level-headedness that keeps the economist from falling in love with what is merely possible (usually in a fairly other-worldly model) and losing sight of what is likely. In other words, most economists and other purported economic experts, notwithstanding their cleverness and mathematical prowess, have no “feel” for how the economy works at all. It’s as if they never see past the trees of technicalities and possibilities to the forest of real economic actions and interactions, not to mention having an appreciation of the relative magnitudes of various factors. This aspect of economics, as the great majority of economists practice the craft, has always put me off, ever since I was an undergraduate; and, if anything, it puts me off even more now, after I have spent half a century trying to do economics right.

(bold mine)

This is from Austrian economist Robert Higgs’ who contributes to what makes for a good economist as published at the Café Hayek (hat tip Mises Blog).

As I have been saying, statistical analysis doesn’t make for economic analysis.

Charts of the Day: As of 2Q 2014,Global Debt has reached 286% of GDP! China Debt at 282% of GDP!

From a recent study by McKinsey Quarterly : Debt and (Not Much) Leveraging

McKinsey summary: Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points.* Developing economies account for roughly half of the growth, and in many cases this reflects healthy financial deepening. In advanced economies, government debt has soared and private-sector deleveraging has been limited. 

My comment: As for developing economies: has this been about financial deepening or about boom bust cycles?

McKinsey summary: Fueled by real estate and shadow banking, China’s total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany.* Several factors are worrisome: half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable. 

My comment: How "manageable" is manageable? Comparing China's capacity with US or Germany signifies a contrast effect--depends on what is being compared. To give you an idea, per capita GDP (IMF measures  2013) of China has been estimated at $11,868 while the US and Germany has $53,001 and $43,475 respectively. If we use this in the prism of looking at the debt levels, then the US and Germany has more capability to manage debt than China has been. Again contrast effect.

Nonetheless the critical issue has been how nations today have become addicted to debt. And debt is no free lunch.

Hong Kong is Doomed for its Anti-Keynesian Model: Budget Surplus, Leaving Cash to the Public by Lowering Taxes

Sovereign Man’s prolific Simon Black explains why Hong Kong is doomed—in the eyes of the Keynesian consensus! (bold mine)

The government committee was clear—if nothing was to be done, the government’s finances would be doomed in as little as seven years.

The Finance Secretary had some tough decisions to make. Raising more revenue for the government over the next few years is crucial.

He was also being targeted and mocked because his ministry’s predictions for economic performance and taxes raised have been consistently wrong every year since 2007.

This is common for government agencies in pretty much every country, but Hong Kong is possibly the worst—they continually underestimate the numbers.

The government will finish the fiscal year ending next month, for example, with a surplus of at least HK$60 billion (probably more, given how horrible they are at forecasting), which is six times more than the finance ministry projected. 

A surplus! Who does that anymore??

Couldn’t they find something else to spend money on? Armored vehicles and combat gear for the police (they did face a massive uprising just a few months ago after all)? Welfare? Crony subsidies? Drones? New government committees and agencies? Surveillance?

At least build a bridge, dammit! What are you going to do with all that extra money now??

I’ll tell you what they’re going to do. The Hong Kong government is so foolish that they’ll… I’m utterly disgusted saying this… they’ll -gulp- give it back to the people…

They’ll institute measures like a salary tax rebate of about HK$10,000, a waiver on property rates, and a PERMANENT increase in the tax allowance for parents from HK$70,000 to HK$80,000 per child—which is a second increase in child tax allowance in three years already!

One of the officials said: “There is a need to stimulate the city’s domestic consumption by introducing measures to leave more cash in the hands of the public.”

What are you talking about, man? Everyone knows that you stimulate the economy by increasing government spending, not reducing it and just leaving the people to decide what they’re going to spend it on. It’s insane.

Reducing already low taxes because you’re running budget surpluses? And you’re only taxing people and companies on the money they earn within Hong Kong? Really? You’ve got much to learn…

Even though following this practice has transformed the once barren island at the mouth of the Pearl River Delta into a global financial and trading center with one of the highest standards of living in the world, this clearly unsustainable bubble of a free market economy, minimal government, and fiscal prudence is bound to end in disaster.

Grexit Drama: ECB Suspends Greece Bonds as Bank Collateral

The Grexit drama appears to be crescendoing.

In a move to forcefully address the stalemate between the new government of Greece and the EU, the ECB has partly withdrawn funding of the Greece financial system by suspending Greek bonds as bank collateral

The ECB’s official statement here.

Marketwatch.com explains the ECB action: (bold mine) 

What did the ECB just do? 

The ECB’s Governing Council suspended a waiver that had allowed Greek banks to use the country’s junk-rated government bonds as collateral for central bank loans. 

Why did the ECB do it? 

Greek bonds are junk rated, thus the waiver was needed to allow the banks to post collateral that could be used for cheap funding from the ECB. One of the prerequisites for the waiver was that Greece remain in compliance with a bailout program.

In its decision, the ECB said it pulled the plug on the waiver because it can’t be sure that Greece’s attempts to secure a new program will be successful.

Beyond the official reasons, the move is seen as a definitive warning that, like Germany, the ECB is in no mood to give in to Athens’s request for a debt swap. News reports also indicated the ECB isn’t open to requests to allow Greece to raise short-term cash by issuing additional Treasury bills in an effort to keep the government funded as it attempts to reach a new deal with its creditors. 

Where does that leave Greek banks? 

It’s not a welcome development. Greek banks have suffered significant deposit withdrawals before and after the January election that brought the antiausterity government, led by Syriza’s Alexis Tsipras, to power.

“This news will likely scare depositors and result in further bank runs,” said Peter Boockvar, chief market analyst at the Lindsey Group in Fairfax, Va.

“This all said, if Greece can come to an agreement with the troika[ i.e., the International Monetary Fund, the European Commission and the ECB], I’m sure the ECB will reinstate the waiver,” Boockvar added.

While the kneejerk reaction in markets has been negative, analysts note that junk-rated Greek sovereign debt made up a relatively small portion of the collateral used by Greek banks in funding operations as of the end of last year. Karl Whelan, economics professor at University College Dublin, recently estimated that Greek banks were using a maximum of €8 billion in Greek government debt as collateral for loans from the Eurosystem as of December versus total loans of €56 billion.

Meanwhile, the ECB said Greek banks will be able to tap funds through a program known as emergency liquidity assistance, or ELA. Under the program, the loans are more expensive and remain on the books of Greece’s central bank rather than the ECB.

The BBC diagram above shows of the share distribution of Greek creditors via holdings of Greek Bonds

The BBC says that : Greece has about €20bn (£15bn; $22.5bn) to repay this year, according to the Greek finance ministry. Economists estimate that Greece needs to raise about €4.3bn in the first quarter.

By withdrawing ECB guarantee, it’s not just about withdrawing liquidity but likewise to implicitly exacerbate the downgrade of what has been already rated as “junk”.

In addition, the remaining lifeline for Greek banks would be the ELA. The ECB’s bailout program is due to expire in February 28, which if not renewed would mean Greece will be on its own. 

So the showdown between the ECB and Greece has become a “game of chicken”. And the “game of chicken” will have consequences. One of them is likely the intensification of “significant deposit withdrawals” which is a euphemism for “bank run”…a systemic Greece bank run. Yet if a run materializes, where will the money go...Germany, Swiss, US or Asia or under the household pillow mattress?

It’s true that since official institutions have become the biggest creditors to Greece, there has been less exposure by the private sector which is probably why the reactions of the financial markets to the ECB hardline stance has hardly been violent…yet. But this lack of drama doesn’t imply that current reactions will project to the future. Or said differently, since sentiments have always been fickle, should a radical shift occur, then the momentum of the ballgame may reflect on such a shift.

And official exposure on high risk junk Greek debt doesn’t extrapolate to free lunch too.

If the Greek government defaults, whether the governments of the Eurozone, IMF or the ECB, someone would have to pay for those losses and that someone, the forgotten man, would be the taxpayers.

As the Zero Hedge points out: (bold original)

yet Bloomberg does bring up a relevant point: "The nominal amounts at stake do illustrate the motives for German resistance to restructuring. Yet a more relevant measure would adjust for a country's ability to absorb those losses. The picture radically changes when that exposure is expressed as a share of 2013 nominal GDP. On this ranking, Germany falls to No. 9 with an exposure amounting to 2.2 percent of its economy's size. France falls to No. 8 (2.2 percent) and Italy to No. 7 (2.5 percent). Portugal (3.2 percent), Cyprus (2.8 percent) and Slovenia (2.6 percent) top the ranking, meaning these countries have the most to lose if Greece decides to write down its public debt."

Should the EU-Greece game of chicken lead to a Grexit, there will be pain for these debt holders. The degree pain will not  be the same, but again there will be pain. The subsequent question is what will be the indirect (non-linear) ramifications?

Of course, in a world where governments have been hocked to the eyeballs with debt, and where central banks have provided the band-aid or patchwork for all the accruing imbalances via the extinguishment of risk conditions through financial asset pump, a Grexit may change the complexion of risk. Risk, like the mythical Phoenix, may resurrect or may be reborn.

Remember all it takes is for a Bear Stearns to lead to a Lehman moment. Could Grexit be the modern day version of Bear Stearns or the Great Depression's Creditanstalt?

Will record high stocks be immune to this? 

Very interesting.

The Relationship between Oil Prices and Philippine Assets Invokes the Butterfly Effect

A researcher from a business broadsheet wrote me if I can help in their article to establish the relationship between oil prices and Philippine financial assets.

Though I would like to help and am profusely thankful for such opportunity, I realized that it would likely take me laborious effort, perhaps more than 20+ or more pages (a paper) to explain the many possible transmission channels of oil prices to asset prices. And not only will this be time consuming to explain complex relationships, in the understanding of how mainstream media operates, complex discussions will only be truncated or simplified--so I backed off.

Here is my reply:

There is what is known as the chaos theory. For instance, mathematician Edward Lorenz explains that a flapping of the wings of a butterfly can cause hurricane in parts of the world (Butterfly effect). The issue of the butterfly effect is the non-linearity of causal linkages. I believe that a lot of your questions invoke the butterfly effect: the linkages won’t be linear, so this will be hard to explain to the public who looks for simplified explanations of complex dynamics.

The Agency Problem as Explained by the Wolf of Wall Street’s Mark Hanna; Sell Side Leverage Risk

A recent comment: …but the (sellside) industry is bullish!!!

But of course, they are bullish. They (We) need to be bullish because that’s the way their (our) bucks are made. Commissions and fees (miscellaneous fees—management, subscription, public speaking, seminars, et.al.) happen mostly when the market have been on the rise. In the local milieu, since short facilities have been nothing more than symbolical, during bear markets, where losses dominate, it would be famine as volume dries up.

So when one follows the money trail, the (our) industry will not (or hardly ever) bite the hand that feeds it! [That exception would be me]

Yet anyone who gives a serious thought would come to realize that the interests of the (our) industry (commissions, fees) are not the same as the interest of an investor (returns). And the interests of the industry are not necessarily compatible with that of the interest of an investor. In fact, the structure of such relationship has an innate conflict. This conflict is known in economics as the principal agent problem or the agency problem.

Investopedia on the Agency problem:

A conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem is that the agent who is supposed to make the decisions that would best serve the principal is naturally motivated by self-interest, and the agent's own best interests may differ from the principal's best interests. The agency problem is also known as the "principal–agent problem."

In the past I wrote, [bold mine]

This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem

Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.

To show you a good example, let us examine the business relationship between the broker and the client-investor.

The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.

How do they conflict?

The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.

Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.

How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.

In the movie Wolf of Wall Street, this conflict of interest or agency problem has been demonstrated in the conversation between Wolf of Wall Street Jordan Belfort and his mentor Mark Hanna at the start of the show.  

(Some caveats: Do away with the drug embellishments. The dialogue comes with expletives. Bold mine)

From MoviesQuotesandmore.com

Jordan Belfort: Mr. Hanna, you're able to...to do drugs during the day and still function, still do your job?

Mark Hanna: Well, how the fuck else would you do this job? Cocaine and hookers, my friends.

Jordan Belfort: Right.

[Jordan laughs awkwardly]

Jordan Belfort: I gotta say, I'm incredibly excited to be a part of your firm. I mean...the clients you have are absolutely...

Mark Hanna: Fuck the clients. Your only responsibility is to put meat on the table. You got a girlfriend?

Jordan Belfort: I'm...I'm married. I have a wife, her name is Teresa. She cuts hair.

Mark Hanna: Congratulations.

Jordan Belfort: Thank you.

Mark Hanna: Think about Teresa. Name of the game, move the money from your clients pocket into your pocket.

Jordan Belfort: Right. But if you can make the clients money at the same time, it's advantageous to everyone, correct?

Mark Hanna: No. Number one rule of Wall Street. Nobody, I don't care if you're Warren Buffet or if you're Jimmy Buffet, nobody knows if a stock is gonna go up, down, sideways or in fucking circles, least of all stock brokers, right?

Jordan Belfort: Mm-hmm.

Mark Hanna: It's all a fugazi. Do you know what fugazi is?

Jordan Belfort: Fugazi, it's a fake...

Mark Hanna: Yeah, fugazi, fogazi. It's a wazi, it's a woozi. It's...fairy dust. It doesn't exist, it's never landed, it is no matter, it's not on the elemental charge. It's not fucking real.

Jordan Belfort: Right.

Mark Hanna: Alright?

Jordan Belfort: Right.

Mark Hanna: Stay with me.

Jordan Belfort: Mm-hmm.

Mark Hanna: We don't create shit, we don't build anything.

Jordan Belfort: No.

Mark Hanna: So if you got a client who brought stock at eight, and it now sits at sixteen, and he's all fucking happy, he wants to cash it and liquidate and take his fucking money and run home. You don't let him do that.

Jordan Belfort: Okay.

Mark Hanna: Cause that would make it real.

Jordan Belfort: Right.

Mark Hanna: No, what do you do? You get another brilliant idea, a special idea. Another situation, another stock to reinvest his earnings and then some. And he will, every single time.

Jordan Belfort: Mm-hmm.

Mark Hanna: Cause they're fucking addicted. And then you just keep doing this, again, and again, and again. Meanwhile, he thinks he's getting shit rich, which he is, on paper. But you and me, the brokers?

Jordan Belfort: Right.

Mark Hanna: We're taking home cold hard cash via commission, motherfucker.

Jordan Belfort: Right! That's incredible, sir. I'm...I can't tell you how excited I am.

Mark Hanna: You should be.

While this may be just a movie, the missives from the conversation which deals with the conflict between client and agents resonates reality; the agency problem.

In short, it is not in the interest of the (our) industry to take risk seriously, for the simple reason that there is no moolah to be made!

Anyway, the problem has hardly been in (our) industry, who have just acting based on what motivates them, the problem instead falls on the shoulder of the market participants who blindly buys into what the industry sells.

Of course, the industry has been supported by media and by the politicians where the latter has the major beneficiary of asset inflation. Moreover today’s asset inflation has been a product of zero bound financial repression policies—designed for easy access on the private sector’s resources via the credit markets and taxes from inflated assets and economies.

So when one uses the ‘appeal to the majority to defend’ or rationalize the status quo or one’s current pumping action, when the tide turns, there is no one to blame but themselves.

Here is more.

I have not encountered any data that shows of the extent of leverage exposure by the domestic sellside industry.

But like everywhere else (China, US or even Bangladesh in 2011), surely a significant degree of leverage has been acquired for local stocks to have reached stratospheric nose bleed record levels. 

The industry’s exposure on leverage can be though margin trades (levered trades extended to clients) or dealer accounts—direct exposure by brokers on the markets perhaps financed via bank loans or via different sources such as intercompany loans, placements, client’s money etc...

Because markets have been rising, these debt based stock market pump party goes on. Remember volume has been incrementally rising on lofty price levels.

But what happens when the market reverses?   

Losing positions will mean margin calls, and margin calls may exacerbate liquidations leading to a feedback loop.

Unless the members of industry would have the self-discipline to close (liquidate) any losing position, an extended stock market rout would most likely impair the balance sheets of many, if not most, firms in the industry. The impairment will be accentuated to entities with high degree of exposure to leverage.

Crashing markets has always been accompanied by big name collapses. For instance, the recent crash in commodity markets have bankrupted major commodity broker MF Global. MF Global reportedly used client money to finance the company’s shortfall. From Wikipedia: On October 31, 2011, MF Global executives admitted that transfer of $700 million from customer accounts to the broker-dealer and a loan of $175 million in customer funds to MF Global’s U.K. subsidiary to cover (or mask) liquidity shortfalls at the company occurred on October 28, 2011. 

The ramifications of the 2008 crash has been the numerous closures or bailouts of major financial institutions (banks, investment houses, brokers, etc…) 

Recently amidst record stocks UK bank, Standard Chartered, reportedly closed and exited from the equity business.

From Reuters, Standard Chartered (STAN.L) Chief Executive Peter Sands moved aggressively on Thursday to reverse the Asia-focused bank's fortunes by closing the bulk of its global equities business and axing 4,000 jobs in retail banking. The lender said it was dismantling its stockbroking, equity research and equity listing desks worldwide, becoming one of the first global banks to get out of the equity capital markets business completely. The decision to close the loss-making division will lead to 200 job cuts, almost all in Asia.

No stock market crash yet, but an exit from equity markets by a major bank.

How much more when the stock market collapses?

My guess is that the incumbent blindness and the asset inflation worship will hurt the sellside industry a lot.

In the local setting, perhaps some may even close.

Caveat emptor.

Gallup CEO on US 5.6% Unemployment Statistics: It’s a Big Lie!

Here is a commentary by one the CEO of the major US pollsters, Gallup, who pushes back strongly on the accuracy of US government statistics. 

Here is Gallup CEO Jim Clifton’s post (or sourced) at the LinkedIn (pointer to Zero Hedge) [bold mine]

Here’s something that many Americans -- including some of the smartest and most educated among us -- don’t know: The official unemployment rate, as reported by the U.S. Department of Labor, is extremely misleading.

Right now, we’re hearing much celebrating from the media, the White House and Wall Street about how unemployment is “down” to 5.6%. The cheerleading for this number is deafening. The media loves a comeback story, the White House wants to score political points and Wall Street would like you to stay in the market.

None of them will tell you this: If you, a family member or anyone is unemployed and has subsequently given up on finding a job -- if you are so hopelessly out of work that you’ve stopped looking over the past four weeks -- the Department of Labor doesn’t count you as unemployed. That’s right. While you are as unemployed as one can possibly be, and tragically may never find work again, you are not counted in the figure we see relentlessly in the news -- currently 5.6%. Right now, as many as 30 million Americans are either out of work or severely underemployed. Trust me, the vast majority of them aren’t throwing parties to toast “falling” unemployment.

There’s another reason why the official rate is misleading. Say you’re an out-of-work engineer or healthcare worker or construction worker or retail manager: If you perform a minimum of one hour of work in a week and are paid at least $20 -- maybe someone pays you to mow their lawn -- you’re not officially counted as unemployed in the much-reported 5.6%. Few Americans know this.

Yet another figure of importance that doesn’t get much press: those working part time but wanting full-time work. If you have a degree in chemistry or math and are working 10 hours part time because it is all you can find -- in other words, you are severely underemployed -- the government doesn’t count you in the 5.6%. Few Americans know this.

There’s no other way to say this. The official unemployment rate, which cruelly overlooks the suffering of the long-term and often permanently unemployed as well as the depressingly underemployed, amounts to a Big Lie.

And it’s a lie that has consequences, because the great American dream is to have a good job, and in recent years, America has failed to deliver that dream more than it has at any time in recent memory. A good job is an individual’s primary identity, their very self-worth, their dignity -- it establishes the relationship they have with their friends, community and country. When we fail to deliver a good job that fits a citizen’s talents, training and experience, we are failing the great American dream.

Gallup defines a good job as 30+ hours per week for an organization that provides a regular paycheck. Right now, the U.S. is delivering at a staggeringly low rate of 44%, which is the number of full-time jobs as a percent of the adult population, 18 years and older. We need that to be 50% and a bare minimum of 10 million new, good jobs to replenish America’s middle class.

I hear all the time that “unemployment is greatly reduced, but the people aren’t feeling it.” When the media, talking heads, the White House and Wall Street start reporting the truth -- the percent of Americans in good jobs; jobs that are full time and real -- then we will quit wondering why Americans aren’t “feeling” something that doesn’t remotely reflect the reality in their lives. And we will also quit wondering what hollowed out the middle class.

***

Jim Clifton is Chairman and CEO of Gallup. He is author of The Coming Jobs War(Gallup Press, 2011).

This is another great example of how “politicians use statistics in the same way that a drunk uses lamp-posts—for support rather than illumination” as warned by Scottish novelist Andrew Lang.

Anyway, welcome to the government statistics skeptic club, Mr. Clifton.