Are the Financial Markets Fighting the FED?

As the US equity markets have been in festivity over the FRESH historical high due to “lower inflation outlook” while simultaneously bidding up equity values in view of more “inflation”, the dichotomy is that Fed officials have been in palpable chorus to admonish about the risks of growing inflation.

Federal Reserve Vice Chairman Donald Kohn recently warned investors of underestimating inflation, ``Don't sell the Fed's concern about inflation short...Further upward movements in inflation would be very adverse to the economy and would, I think, require policy actions.'' Mr. Kohn further notes that his concern is more to the side of inflation than of a sagging economy, ``The risks to my outlook for economic activity may be skewed to the downside, while those to my forecast of gradually declining inflation are tilted to the upside,'' Kohn said. ``In the current circumstances, the upside risks to inflation are of greater concern.''

Charles Plosser, newly installed president of the Federal Reserve Bank of Philadelphia, likewise used his inaugural address to tackle on inflation risks. He commented that ``there is some cause for concern...Despite recent hopeful news on the inflation front, the inflation outlook remains uncertain" and that "there is a significant possibility that inflation rates will remain above those consistent with price stability for some time." Plosser addressed the need to be vigilant and act when necessary, ``So we need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy's long run performance...if unacceptably high rates of inflation persist or public confidence in long-run price stability seems to diminish, additional monetary policy tightening may be necessary."

Fed Chief Ben Bernanke, while acknowledging the substantial weakness in the housing sector was in a quandary on the degree or extent of the probable fallout, ``It is a little difficult how the dynamics are going to play out”, although he waxed optimistic, "At the same time, I think there are some strong fundamental underpinnings that should help the housing market over the medium term, he said. These include: a good job market, strong income growth, demographics and continued low mortgage rates... To this point, other parts of the economy are remaining relatively strong”.

What these Fed officials have been trying to say has been antithetical to the expectations of the market. In other words, the financial markets have been at odds with the Fed!

I’d like to add that the recent speech by Fed Chief Ben Bernanke at the Washington Economic club highlighted the structural imbalances seen with the government’s welfare or entitlement programs, particularly the Medicare and the Social Security System. He notes,

``The fiscal consequences of these trends are large and unavoidable. As the population ages, the nation will have to choose among higher taxes, less non-entitlement spending, a reduction in outlays for entitlement programs, a sharply higher budget deficit, or some combination thereof...

``Assuming it unfolds as expected, the projected aging of the population implies a decline over time in the share of the overall population that is of working age and thus, presumably, in the share of the population that is employed. For any given level of output per worker that might be attained at some future date, this decline in the share of people working implies that the level of output per person must be lower than it otherwise would have been. In a sense, each worker’s output will have to be shared among more people. Thus, all else being the same, the expected decline in labor force participation will reduce per capita real GDP and thus per capita consumption relative to what they would have been without population aging.”

These are hardly bullish factors for US assets going forward as about 78 million baby boomers (birth years: 1946-1964) enter into the retirement age in the coming years.

Remember without adequate savings, you would find retirees selling assets to finance consumption. Further, the imbalances, as a result of present demographic trends, (assuming its continuity) would lead to a smaller ratio of workers subsidizing for each retiree, whose lifespan would have been prolonged by the unfolding technological breakthroughs in healthcare sector, would take its heavy toll relative to the nation’s fiscal position.

While of course, Bernanke and the Fed may use monetary tools to “raise the savings rate” of which he advocates as a principal solution to the present dilemma, perhaps in cognizance of the degree of leverage the country is exposed to, which makes the economy highly interest rate sensitive, he has instead tossed the problem to the legislative branch for resolution via his “recommended” reforms. Bernanke said, ``Reform of our unsustainable entitlement programs should also be a priority. The nature and timing of those reforms will be determined, of course, by our elected representatives.” It becomes a case of a “hot potato” where no one wants to own up to the festering problem.

Election Season: Big Brother’s Hand “The Gorilla in the Room”?

This leads us back to the present fix, “Why are the markets rising amidst a mid-cycle slowdown?”

Taking in another view from a different lens, it is important to consider that with the fast approaching political season in the United States, conspiracy theories have been floated as possible stimulus to the present dynamics in the financial markets. The supposition is that government’s covert hand had been utilized to create conditions that would favor certain candidates or special interests groups whose political interests are at stake.

During the past month, as the seasonal strength favored rising gold prices, an abnormal degree of selling pressure sent gold prices plummeting. I initially suspected of government’s hand in trying to “manage our inflation expectations” by dumping on the gold market, and was proven right, apparently my suspicions have been confirmed by more sales by the European Central Bank according to their recent disclosures. This seems to have been timed as the calendar year for the European Central Gold Sales Agreement closed last September 26^th, where they are allowed to unload 500 tonnes annually.

But it is not only in the gold market where government’s hand was suspected to have intervened; there were signs in the energy markets too.

For one, the widely followed and the largest commodity index, the Goldman Sachs Commodity Index had its weightings reconfigured such that Unleaded gas which was previously allotted 8.72% was adjusted down to 2.3% while the Reformulated Gasoline Blendstock for Oxygen Blending futures contract was adjusted to the upside from 0 to 2.37%. The sharp fall of unleaded gasoline prices which took the broad energy market down with it had been blamed as a political handiwork to the network behind the investment firm once run by Treasury Secretary Henry Paulson. This comes in the light of President Bush’s decision to delay the adding deposits to the US Strategic Petroleum Reserves last April.

Dave Forest of Casey Research identifies another route where perceived manipulation of prices could have been effected. Mr. Forest wrote,

``Another lesser-known influence on oil prices is the “crack spread.” This is the difference between the price that oil refiners pay for crude and the price they receive for the gasoline they produce. Put another way, it’s the profit margin that refiners make on their products.”

``Currently, the crack spread is at - in the words of the U.S. Energy Information Administration - “unusually low levels.” This means that refiners are selling gasoline for little more than the cost of the oil they purchase. This makes no sense from a business perspective… generally in such a situation, refiners would simply up the sales price of their gasoline, improving their margins...

``Why would these companies voluntarily take lower profits? There’s no way to know for sure, but it’s a certainty that the White House and Big Oil are close friends. Witness Dick Cheney’s ties to Halliburton, and George Bush’s background in the Texas oil patch. Might the Republicans be calling in a favor from their refinery manager pals, asking them to keep gas prices down until November 7 has passed?

It is not only in the commodities market, where manipulations have been suspected, the recent rise in the equity markets have likewise been said to have benefited from behind the scenes interventions. Mish Shedlock of WhiskeyandGunpowder quotes John Succo, a professor in Minyanville (emphasis mine),

``In 25 years of trading, I haven't seen stock prices act this way. On any disappointing number (ISM, for example, this morning), stocks react vehemently positively.

``And it's not stock by stock, brick by brick, which is how a stable bull market is built. It is all index led. Tick data today is just another example. They hit +1,000 probably 20 times today and +1,500 twice. Surreal.

``I have my own theories. In a world where geopolitical events are broiling, we have political structures desperate to remain in power. It is possible to believe that in such a world desperate measures like buying stocks by governments (we know Japan did this for quite a while) is certainly plausible. Given the action, I say it is probable.

``The last few years [are] all about liquidity. Who is responsible for that?...And just in time for the elections.”

``I made the big leap yesterday saying governments (no price sensitivity) were buying index futures in the U.S. This is the only answer I see for the odd behavior. Stocks not in an index are severely lagging.

Tick data in our local lingo means either a consummated transaction was a “buy up” (uptick) or a “sell-down” (downtick). What Mr. Succo suggests was that in the face of bad news, there were oddly signs of PANIC BUYING, as measured by an extremely aggressive uptick/buy up counts. Mr. Succo finds no other party except governments being price insensitive as responsible for these recent actions. He says government intrusions are distorting market signals and giving the public the wrong way to price risks and at the same time create a moral hazard problem of “providing easy credit for even worst companies.” Well, that is what I have been talking about, inflationary biases to protect special interest groups.

Of course, except for the gold sales, all of these could be dismissed as outright speculation until some data could be proven to support these allegations.

Bullish Momentum, Flexibility and Trading Advices

According to George Soros, ``One can never be sure whether it is the expectation that corresponds to the subsequent event or the subsequent event that conforms to expectation. The segregation between thoughts and events that prevails in natural science is simply missing.” In this context, I remain uncertain of my convictions over the interim simply because events have turned against them.

Yet as prudent investors we do not fight the tape. In the invaluable words of legendary trader Jesse Livermore ``There is only one side of the market, and it is not the Bull side or the Bear side, but the right side.” We have to remain flexible, in view of these circumstances.

Figure 3: Contraryinvestors.com: Second Year Presidential Cycle Pattern

The tape tells us that momentum favors the bulls at present for reasons aside from the fallacious “lower inflation expectations" most possibly based on several factors such as seasonality; a switch from the weakest to the strongest period of the year, the underlying year end strength of the second year of the Presidential cycle (see Figure 3), ``the end of the fiscal year for mutual funds and other institutional investors on Oct. 31 ends selling by funds anxious to take a tax loss to offset the year's profits and sends institutional money flowing back into the market and measures of short-selling on the New York Stock Exchange and the Nasdaq have reached multiyear highs (a seven-year high in the case of the New York Stock Exchange), so there are still lots of skeptics out there to be convinced.” according to analyst Jim Jubak.

Of course, the supposed government interventions to prop up the markets for political goals could be another short-term booster, which could translate to a run until at least November.

Lastly, I think the most important factor which underpins the entire bullish psyche today is premised on inflationary biases whether through manipulation (alleged government intervention in several fronts of the market) or through Soro’s “expectation that corresponds to the subsequent event” (financial markets ties the hand of a reluctant Fed and succeed to force them to further loosen up the speculative landscape) or through remediation of one bubble to another (shift from equities to housing back to equities?).

As I wrote to a special client, “the inflation genie is what inspires the market to resume its climb upwards regardless of the risks of greater-than-expected slowdown. It's simply called addiction, from which the Fed and the incumbent politicians would be all too willing to accommodate for the primordial purpose of power retention.”

As a last piece of advice; trade only amounts you are willing to risk and importantly MIND YOUR STOPS!

TailPieces

One of my favorite analyst at Morgan Stanley covering the Asian markets, Mr. Andy Xie was reported to have recently resigned due to a controversial email he sent internally but have leaked outside and allegedly caused embarrassment to the firm which led to his rush departure.

FinanceAsia quotes the alleged intriguing derogatory comment on Singapore from Mr. Xie, ``Actually, Singapore’s success came mainly from being the money laundering centre for corrupt Indonesian businessmen and government officials. Indonesia has no money. So Singapore isn’t doing well. To sustain its economy, Singapore is building casinos to attract corrupt money from China.”

Two important quotes come into my mind, one, never to judge a book by its cover and second, from novelist Honore de Balzac, Behind every great fortune there is a crime. Just a food for thought though.

The growing sophistication of Asian M&A

As an Asian bull, I noted that the ongoing financial integration will boost valuations aside from the activities in the regional corporate arena.

FinanceAsia in their latest article "The growing sophistication of Asian M&A" interviewed, Gordon Paterson, Citigroup's head of regional M&A. Here are some important developments from the standpoint of Mr. Paterson...

> “Transactions have been mostly intra-Asia, partly because the competitive landscape has changed. In the past strong domestic companies competing for assets were the exception, now this is the norm.

> “I'd say that today the cost of capital for emerging market companies is very competitive compared to developed market counterparts and this is fuelling transactions. This is across the board and not just related to the fact that the cost of debt has gone down. In many cases, especially across emerging markets, Asian companies view risk profiles of the countries more favourably than their European and North American counterparts

> “Over the years the very limited avenues of financing have given way to local markets with depth and experience to finance deals. The high yield market may not yet be developed to the stage of the US market but it is certainly developing quickly and in the right direction. Liquidity in the market is high hence alternatives and sophistication are increasing. Convertibles, for example, even in sponsor-led deals are playing a bigger role.”

Overabundance of Liquidity, more access to financing, improving corporate profiles and developing capital markets are indeed helping underpin the expansionary M&A activities in Asia.

Go no further, the boom is yet unraveling.

Wisdom of Money:The Way You Think Dictates Your Spending Habits

Wisdom of Money imparts a very important message not just on spending but on investing habits, quoting them verbatim...

Wisdom of Money: The Way You Think Dictates Your Spending Habits

Prosperity thinking can be defined as a trusting attitude that things will work out. It is an optimistic state of mind, and an empowered orientation toward money. Prosperity thinking means aligning our beliefs, attitudes, expectations, goals and behaviors toward realistic levels of abundance, confidence and gain. It increases financial and personal self-esteem and assists in using our feelings and intuition to deal with money more successfully.

Poverty thinking, on the other hand, is a mistrustful state of mind that says things will not work out. It embodies pessimism, fear, and a passive relationship with money. A poverty thinker aligns beliefs, attitudes, expectations, goals and behaviors toward unrealistic levels of scarcity, fear, and loss. It diminishes our financial and personal self-esteem and decreases confidence in handling money. Such messages can cause us to distort how we perceive an event and explain why we react irrationally. Almost everyone, including highly wealthy people, is a victim of poverty thinking to a certain degree.

Prosperity and poverty thinking are two important concepts for understanding the psychology of money. Studying various spending personalities and behavioral patterns provide us with an awareness for making smarter financial decisions of our own. Because the mind takes precedence over our actions, to think and feel more prosperous creates new opportunities for experiencing financial freedom.

World Equities: Knockin’ on Heavens Door or Facing Hell?

``The game is always changing and evolving, and it pays to pay attention to new theories. The bottom line is to always be open-minded, to try and improve the way you do things." -Brian Cashman (GM, NY Yankees)

I have spoken to around three brokers over the week and found all of them overly bullish. I guess that is the nature of brokers, to be bullish because selling stocks or inducing clients to trade would have to come from optimistic expectations.

What drives their bullishness today is no less than the behavior of the Phisix, which has, as pointed out previously, tracked closely the movements of the US benchmarks as with most of global equity benchmarks. The Phisix like their US counterparts seems to be like Bob Dylan’s “knocking on heaven’s door”.

Figure 3: Phisix: Knockin’ on Heaven’s Door?

In theory, excessive bullishness shown by brokers possibly means that most clients who have been egged to buy or enter the market have already done so, leaving little room for more buying activities that could lift the market to higher levels. In short, it is a crowded traded. This, in essence, suggests that inordinate bullishness translates to eventual market tops.

But who has lifted up the Phisix lately? Obviously based on last week’s data foreign money had been a critical factor with locals apparently having reduced their interest over speculative activities over the broad market. Could it be that the local investors have abided by PSE’s admonitions and instead joined their foreign counterparts in accumulating blue chip issues too? Hmmm... Or is there a possible something else brewing at hand?

Of course with the momentum going in one’s favor, would one even care to listen to what may derail it? As we have previously noted, the average investors normally extrapolate the immediate past as the likely path of the future.

I’d like to point out to you that the ongoing activities in the US Treasuries market have not been singing hallelujahs as the consensus have it. In fact, if one looks at the present activities, the rapid decline of the 10 year bond yields point towards, expectations by bond investors of an ‘accelerated’ mark down in the US economic growth cycle and inflation expectations as shown in figure 4.

Figure 4: Stockcharts.com: Bond Yields Suggests Big Slowdown Ahead

While our local brokers have been outright perky, believing that the Philippine markets could perhaps be insulated from external events, we gladly point out that key US equity benchmarks have their own version of “Knockin’ on Heaven’s Door” probably by Avril Lavigne...

Figure 5: Stockcharts.com: Knockin’ on Heavens Door or Facing Hell?

...or if not Ozzy Ozborn’s Facing Hell? As you can see in Figure 5, both key US equity benchmarks have reached critical resistance levels following the recent run-up. Yet, following a touch of these critical highs we have seen them fall back to support levels.

On the technical picture, we find mixed signals with a bias (ok, my bias) towards the downside. Retracing from last week’s record highs draws a bearish “double top” formation, accompanied by the still intact bearish “rising wedge” formation. We also have the Moving Averages Convergence Divergence (MACD) indicators, shown in the lower window, as indicating an overbought position too.

If these US equity benchmarks successfully breaks above the defined resistance levels then I expect the Phisix to likewise sustain its rise and equally break May’s high. Then one should reposition into the market, as global markets are likely to position for a Christmas rally in spite of an economic global downturn. Anyway, world’s endless stream of money has to go somewhere, right?

On the other hand, if the prospective slowdown in the US finally comes home to roost for US equity investors, then expect some pretty big correction, from whence we stand. And so forth with global indices and the Phisix.

So it’s your choice, Bob Dylan or Ozzy Ozborn?

Thai Coup: Hardly A Ripple

``The coup has also highlighted some of the fragility inherent in Thailand's social fabric: so very much of the nation's unity and order rests on the shoulders of one remarkable man, His Majesty, the King.”-Andrew T. Foster, Director of Research, Portfolio Manager, Matthews International Capital Management, LLC

As the military led by a group known as “Administrative Reform Council” surrounded the national seat of the Thai Government to successfully topple Prime Minisiter’s Thaksin Shinawatra’s government, there had been widespread speculations as to extent of the impact of such political development to the regional financial and economic sphere.

One major distinguishing factor that has so far contributed to the triumph of the changeover has been that the military group, who were seen adorned with yellow ribbons meant to demonstrate their loyalty to Thailand’s monarch, His Majesty King Bhumibol Adulyadej, had apparently the blessings of Thai King itself. In short, two possible scenarios emerge: it could be possible that perhaps the King himself impelled for PM Thaksin’s overthrow, or King Bhumibol Adulyadej could have simply endorsed the coup d'état to give legitimacy and avoid further deterioration of events.

Many pundits have thrown their opinions as to the possible repercussions. A surprisingly big number of analysts, mostly from foreign institutions-gleaned through Bloomberg’s interviews, have said that this opportunity could signify a “screaming buy” given that the present political impasse would be disentangled given the makeover. Some like those from Morgan Stanley downgraded their Thai outlook.

In the past I have noted that domestic volatility have markedly ebbed as global markets have slowly integrated...

Figure 1. Yahoo: US/THB; stockcharts.com Thailand’s SETI

As figure 1 shows so far the impact has rather been muted. The Thai baht lost a measly .4% while most of damage was seen via the SET or Thai’s main equity benchmark down 2.7% over the week. Thai bonds even rallied over the week.

To give it a more balanced perspective, Asian currencies have been largely down led by Indonesia’s rupiah down .7% according to Bloomberg, while the Philippine Peso closed .18% to Php 50.35, Malaysia’s ringgit fell .1% to 3.675 and Singapore Dollar S$1.5853. In short, there had been other factors driving the region wide currency declines more than simply the Thai upheaval. This in contrast to the equity benchmarks which were mostly up except for the biggest loser in the Thai’s SET.

For as long as the Thai incident would remain contained, orderly and peaceful, we are unlikely to see a contagion effect towards other the ASEAN nations which I view as rather low impact low probability event. In contrast to the Asian Financial Crisis in 1997, where structural infirmities such as pegged currencies, massive deficits and mountain loads of external or dollar denominated debts gave way to simultaneous capital flight, today’s ASEAN economies appeared to have learned from the past and have adopted a more flexible stance.

As for General Sonthi Boonyaratkalin leader of the coup, like the JRR Tolkien masterpiece the Lord of the Rings, we will see if he will be consumed by the power he arrogated upon himself (what I call “personality based politics”) or indeed stay loyal to the cause of the King and permit for a transition government. By the way, coup has been a way of life for the Thais; this has been the 18^th during the past 60 years for the Land of the Smiles!

Finally, I’d like to make a short comment on the observations of a very high profile contemporary, who made a ‘rationalization’ that Thursday’s decline at the Phisix had been due to the Thai coup. Our expert analyst simply parroted what the average investor would have thought. However, being an analyst, I guess I’d be responsible enough to point out that in spite of the impression of so-called “foreign-investors-pulling-out-of-ASEAN” due to the Thai development, internal market data showed that foreign buying heavily supported the Phisix in nominal and in broad market terms, which simply belies this claim. Further, Ayala insiders or the Zobel group represented by MERMAC sold 6.9% or Php 10.56 billion worth of AC shares to a foreign group on a special block sale also during that fateful day. So listen to your high profile analyst, who is after all, not after the truth, but for publicity (smiles!).

A Brewing Financial Storm or A Wall of Worry to Climb?

``With so much complacency around and with such a high propensity to speculate in just about everything among all classes of investors, a nice crash should not entirely be ruled out.”- Dr. Marc Faber

I know, to some I may have sounded like an alarmist predicting a financial storm ahead. Yet despite my interim morose outlook, the financial markets in particular, the global equity markets continue to react antithetically against these premises.

Yet evidences continue to mount in support of my concerns. Recently, I have assigned the weaknesses seen in the broad spectrum of energy prices to dampening demand in the US. Paul Kasriel, Chief economist of Northern Trust, points to the declining trend of US Petroleum imports in quantity as shown in Figure 1, as probable signs of demand contraction.

Figure 1: Northern Trust: Declining Energy Related Imports

Writes Mr. Kasriel, ``So, there would appear to be more evidence supporting the demand-side explanation for the recent decline in oil prices than the supply-side explanation. If it is weaker demand that is explaining lower oil prices, then do not look for a rapid re-acceleration in consumer spending or domestic spending of any sort. To be sure, a decline in energy prices will lead to stronger consumer spending than otherwise would be the case. But this would be a second-order effect if the decline in oil prices is the result of a restrictive monetary policy.”

The same cannot be said of China whose crude oil imports jumped 35% in August according to Xiao Yu of Bloomberg. I’d like to remind you that during the horrific “risk aversion” selling last May, Crude Oil despite the much touted speculative funds or “terror premium” factor largely attributed to its runup, was largely unaffected by the cross asset class selloff. In short, it is unlikely that today’s actions in the energy sector have been due to merely reallocation by the speculation money.

Figure 2: Fullermoney.com Oil’s Countertrend risk since 2001

Or could it be that the present softening of oil’s prices as merely a technical hiccup over its long term trend as had been the case since 2001, (see Figure 2)?

Analyst Barry Ritholtz echoes a similar view on the apparent corrosion of consumer demand (emphasis mine), ``In the past 16 Federal Reserve tightening cycles, there has been one true soft landing in 1994. I continue to look at that not as impossible, but as a low probability event.... My largest present concern is oil and other commodity prices. It's no coincidence that gas, oil, gold, aluminum and copper all have dropped at the same time. I read that as signs of a global slowing in demand.”

At the same time, we likewise hear parallel sentiments and warnings from the head honchos of the multilateral agency the IMF as Mr. Rodrigo Rato (Managing Director) and Mr. Raghuram Rajan (chief economist).

I watched Mr. Rajan’s interview at Bloomberg where he commented that the world economies have been growing strongly supported by emerging domestic demand. As an example, private demand has made up the bulk of Japan’s economic turnaround as shown in Figure 3 following a decade long slump.

Figure 3: JETRO: Domestic Demand leads Japan’s Recovery

However, Mr. Rajan thinks that while there could be some impact on the world economy by an economic downturn in the US, he is uncertain as to the degree or the magnitude of such impact.

Where the marked deceleration in the US real estate industry had been carried over by mainstream media accompanied by much heralded warnings, such swing in sentiment could have probably prompted markets to react in a diametric fashion, hence, the continued buoyancy (climbing a wall of worry?).

Yet when we talk about sentiments, it is noteworthy to point out that the global equity markets have shown extreme complacency as measured by the VIX chart (see my August 28 to September 1, edition, Market Dissonance: Bull or Bear Amidst A Slowdown?).

Moreover, if one takes a look at how credit spreads are presently behaving in the bond markets, as another measure of sentiment; we see similarly the same pattern.

Figure 4 Yardeni.com: Moody’s Corporate spreads

The spread between the yields of corporate bonds and sovereign debt instruments reflects investor sentiment. When investors are wary over the prospects of the economy, lenders naturally become hesitant to tidy over money to corporations resulting to higher yield differentials. Today, despite the pronounced “moderation”, US corporate bond spreads remain at very low levels signifying a high degree of complacency see Figure 4 courtesy of yardeni.com (Thank you James!).

Figure 5: Bank of International Settlements: Default rates and CDS markets

In addition, the lax environment can be seen in default rates and forecasts as shown in Figure 5, seen through the eyes of the Credit Default Swap markets.

Credit Default Swaps (CDS) are derivative instruments that swap or transfer the risks of credit exposure of fixed income products between parties.

Let’s hear it from the central bank of the world’s combined central banks, the Bank of International Settlement (emphasis mine), ``Major corporate spread indices stayed well above previous lows in the United States despite indicators of credit quality that showed few signs of deteriorating. Moody’s forecast for the 12-month trailing speculative grade default rate for January 2007 was revised down by August 2006 to 2% from over 3% six months earlier, continuing a pattern of downward-revised forecasts over the past few years (left-hand panel). Expected default frequencies, as calculated by Moody’s KMV based on balance sheet information and asset price volatility, were also stable at low levels for firms within rating categories (centre panel). The persistence of higher spreads in the face of a broadly unchanged outlook for credit quality is consistent with indicators showing that the appetite for credit risk never fully rebounded from the turmoil in corporate bond and CDS markets in the second quarter of 2005 (right-hand panel).”

While there have been some signs of turbulence as a result of the global shakeout in May, investors have basically assumed the present placid trends as the future’s trajectory, note the phrase “broadly unchanged outlook for credit quality”. That’s how smug the financial markets are relative to risks. Evidently, that’s also a product of an ocean of liquidity. Now again, we question this tranquil outlook in the face of economic growth “moderation” whose repercussions remain undetermined but whose markets has been obviously priced for “perfection”.

Figure 6: PSE and Dow Jones World Index

Figure 6 shows that the world markets have been, as I have pointing out ad nauseam, largely behaving in synchronicity. The sheer gargantuan size of the liquidity pool and its continued growth, in the global financial system has led investors to stretch for returns. Further, the digitization of money and credit plus the technology enabled integration of the financial markets has allowed capital markets to deepen, reduce barriers and domestic volatility, facilitate for a seamless flux of capital that has prompted for resonating movements of these benchmarks. For instance, the Phisix and the Dow Jones World Index has moved as one or has seen a stronger correlation over the past quarter relative to the previous period.

I have to admit though that the recent behavior of the Phisix had been that of an upside momentum following last Friday’s breakout. Volatility as measured by the Bollinger band seen in the upper window appears to signify continuity of such upside momentum, again in consonance with the activities of world markets, with particular emphasis to the US markets.

Of course for the time being, my fears could be misplaced considering that one, the financial environment remains unrestrictive which means contemporary avenues or channels of liquidity remains as potential fuel for any added upside moves. Besides, the loose lending standards may cushion whatever shortfall US consumers may yet face over the interim and may extend its heavily levered spending binges.

Eric Roseman, Investment Director of the Sovereign Society wrote (emphasis mine), ``When long-term U.S. interest rates are below 5%, it's probably not the time to get bearish on global economic growth and commodities. Keep in mind that previous economic recessions began with the Federal Funds rate closer to 7% and long-term rates at 6.5%, or higher. Global liquidity has eased somewhat since mid-May. But overall, bank lending is still very robust around the world and companies are still logging respectable earnings growth, though likely to be moderated over the next several months. Unless a geopolitical event happens that tips the global economy into recession, this bull market will still be alive and kicking.”

Second, lower energy prices and lower yields are both stimulative. Lastly there are signs of incremental increases in wages and accelerated capital spending that may yet cushion the decline in the US real estate industry and extend the spending binges of the overstretched consumers.

Yes, my fears may have yet to turn into reality but I am not throwing caution into the wind and withdrawing my cynicism towards the present market climate until we see more vivid signals from the financial markets that would merit increased exposure. Instead, I would rather take this opportunity to trade the market.

Finally, my suspicions on gold’s recent downdraft have been confirmed. According to this Reuter’s report, ``According to the weekly balance sheet issued by the European Central Bank, gold holdings fell 114 million euros in the week to September 8, the biggest drop in two months. The ECB said this was due to sales by two central banks, but did not name them. Separately, the Bank of Portugal announced that it had sold 20 tonnes of gold "in recent months", taking its total for the current year of the agreement to 45 tonnes.”

Governments will do anything as to achieve its short term goals usually with long term unintended consequences. When governments distort markets we know that the effect is likely to be short-term. Moreover, governments have had ignoble track records in the markets. One can just be reminded of Britain’s Exchequer Gordon Brown controversial gold sales in 1999 which incidentally was at the record low of around $250 per ounce. And to consider governments are suppose to know what’s best for you and me. Just imagine the losses to the British taxpayers borne out of this miscalculation. On this premise alone, I see a continuing bullish trend on the monetary metal even as it may be weighed down by short term volatility emanating from government interventions.

Foreign Funds: Rotation to the Telecoms?

In the local market, recently one sector had been a steady beneficiary of foreign portfolio inflows over the past few weeks. It appears that an ongoing rotation abroad has also found a similar trend here.

Figure 7: Stockcharts.com: Rotation towards the Telecoms?

The chart in Figure 7 shows that in the US, the S&P 500 Telecommunication Services Index (black line), which I recall in 2002 had been strongly correlated with the movements of PLDT, has corralled the bulls for an accelerated upside momentum.

We see similar upside momentum over at the Dow Jones Emerging Market Telecoms benchmark as well as a spike in PLDT shares (lower window) traded in New York. From the looks of it, these fund rotation may continue given its current motion.

Fundamentally, if one considers subscriber growth as basis for projecting revenue growth, I find that the fantastic growth clip for telecom stocks as having peaked out. However, as I have noted the hunt for yields may continue and the formerly out-of-flavor telecom issues abroad may equally find a spillover at local issues.

If the bullish momentum towards these issues continues to lead the market over the interim, one may consider surfing them.

Telecoms: Closing the Digital Divide

The telecom sector is one areas of the controversial “digital divide” said to be the restricted to the realm of the “haves” over the “have-nots”. According to the International Telecommunications Union (ITU), ``Over the last 10 years, the digital divide has been shrinking in terms of numbers of fixed phone lines, mobile subscribers, and Internet users.”

Figure 8: ITU: Closing the Digital Divide

Figure 8 shows that the tremendous growth rate in the developing world is fast closing in with that of the developed world.

In the Philippines, as an outgrowth of deregulation, subscriber take up has increased substantially. According to Nortel, ``The NTC reports that the number of mobile subscribers has doubled since 2002, reaching 32.9 million subscribers at the end of 2004, for a penetration level over 41 percent or an average of two mobile phones for every five citizens.”

In the next few years about 1 in 2 Filipinos would be a mobile subscriber; this means that technological innovation brought about by entrepreneurial undertaking and competition has driven down cost of ownership or increased the affordability levels that have enabled the “have-nots” to enjoy the privileges previously limited to the “haves”. We will see the more of same trend across the digital sphere. Matthews Funds Asia says it best (emphasis mine), ``the lifeblood of technology industries is still innovation. It sustains the industry through varying economic cycles. It is embedded in the strategies of successful companies. Asian technology appears to be headed toward an equilibrium, in which knowledge will be as much a driving force as capital, and marketplace demand more influential than government decree. The real era of innovation in Asia may lie ahead.”

Global Markets: A Financial Storm Ahead?

``A man can fail, but he isn't a failure until he blames someone else." J. Paul Getty, industrialist

Now to the bad news. With more evidences emanating from a considerably softening US real estate industry percolating into a wider spectrum of its economy, market signals appears to be gradually confirming risks of an accelerated decline which may surprise the “goldilocks” outlook espoused by mainstream market participants.

First, the rallying global bonds appear to be well underway indicating future liberal policies in the face of the prospects of more intensive economic decline. Recall, that the bond markets lead the Fed policy directions as we previously tackled in our past editions. According to the well respected independent research outfit BCA Research (emphasis mine), ``There is scope for further downside in yields as the market brings forward its expectations of Fed rate cuts in response to the faltering U.S. housing sector, and as global growth slows. While all major bond markets will stay in rally mode, U.S. yields will fall relative to the rest of the G7, as is typically the case during Treasury rallies. Bottom line: stay bullish on global bonds, and overweight the U.S. market.”

BCA thinks that there is room for a deeper decline in bond yields and that the bond markets have been positioning in anticipation that global central banks led by the US Federal Reserves will trim rates in the future. If this outlook should hold true, trimming of rates by the Fed has been typically associated with or in reaction to a contraction or a recession!

Figure 3 stockcharts.com: US dollar breaks to the Upside!

Second, the US dollar broke on the upside following a rangebound activity as shown in Figure 3 for most of the August until last week. The Bollinger band on the lower window denotes of low volatility over the same period. And low volatility implies upcoming heightened volatility, in which case, the current upside breakout could signify a nascent upside trend for the US dollar.

According to Morgan Stanley’s Currency analyst Stephen Jen, ``Investor risk-reduction could ‘turbo-charge’ the dollar and, ironically, lead to dollar strength…we think that the dollar could actually rally in a deep recession.” In the present setting, a strong US dollar supported by rallying bonds amplifies the case of a severity of a potential hard landing.

Figure 4 stockcharts.com: End of A Summer Rally?

Third, major US equity benchmarks as shown in Figure 4, appear to have broken down synchronically from their bearish rising wedge formation, as the summer season ends.

Moreover, the conventional fashion of the recent breakdown had been accompanied by higher volume giving strength to indications that such downside moves could in most probability, continue. The apparent erosion of the strength from the bulls lends credence to the seasonal infirmities of September for US equities.

Figure 5: stockcharts.com: WTIC Breaksdown!

Fourth, oil prices have likewise broken down from its 3 year trendline as shown in Figure 5. Is it the end of the bullmarket in Oil? Over the long horizon...I doubt so. But the present motion certainly seems to corroborate the view of the possible reemergence of a “risk reduction” trade.

Figure 6: stockcharts.com: Gold breaking down too?

Lastly, gold prices despite having rallied early last week appeared to have succumbed to the prevailing dour sentiment in the financial markets. During the last three sessions, gold declined to test on a major support level at $607 for the fourth time in three months on Friday, as shown in Figure 6 (blue arrows).

Nonetheless, despite the bullish end of year seasonality outlook which favors higher prices for gold, the interim technical picture reveals of a trend pattern of lower highs and a flat support level. This “descending triangle” pattern translates to losing vitality for the bulls to lift its prices, while on the other hand allowing the bears to accrue more momentum in their favor to wrest control of gold’s price direction.

Further, the low volatility on the lower window of the chart appears to support the case of a forthcoming big swing! Either Gold breaks to the upside, over and above the $640 level to expunge the bearish pattern or it breaks down from $607, the latter of which is more likely given the uniformity of signals emitted by the cross-asset class benchmarks.

The bears may even lead gold to test its previous low of $540 where I believe potential support from the seasonality factors or physical demand would step in. I strongly suspect too of the Europe’s Central banks unseen hands in the recent decline with the close of the European Central Bank Gold Agreement on its calendar year which ends on the 26^th of September. You see, central banks have the motivation to “manage” our inflation expectations by keeping a lid on Gold’s prices among other measures as altering statistics to suit their needs.

However, over the long run, I remain bullish on gold even as present trends appear not to be supportive of its short-term case. Anyway, no trend goes on a straight line.

In the same context, despite the recent gains of the Phisix, we see that the risks levels have risen enough to merit once again raising cash as to preserve capital in the assumption of a furtherance of these recent trend signals. It remains to be seen if the domestic equity benchmark and the peso could withstand, be insulated and diverge from the potential untoward developments in the financial markets abroad.

For the moment it looks like that the deflationist camp is getting ready to open the champagne bottles.

PSE Warns of Speculation: Missing The Forest for the Trees

I’d like to also point out that the Philippine Stock Exchange (PSE) recently issued a word of caution to the public on what appears to be growing speculative activities seen in the broad market which I find as quite bizarre or if not ludicrous. According to the PSE, ``Based on the recent two (2) months of trade data initially reviewed, there are nineteen (19) listed companies that have increased its share price ranging from 30% up to 860%, breaching trading bands under the PSE Rules. Total traded volume and value for these stocks were 7B shares and Php2B, respectively, and amount to 10% of the total value of PSEi for the same period. Approximately, 60% of active Trading Participants traded at least one (1) of the stocks in review and 24% traded three (3) or more. These stocks also consistently reached 50% a number of times within the same review period and some for two (2) to three (3) consecutive days. All these activities happen amidst consistent general declaration of the issuers to have no known basis for the steady climb of its share prices.”

While I admire the PSE on its “good faith” for its attempt to curb what appears to be a snowballing of punts or the swelling of speculative activities, it seems that the PSE has overlooked the fact that financial markets in general have intrinsic or natural inclinations to gyrate based on short-term speculations. The PSE should take heed of the words of the prominent industrialist J. Paul Getty, founder of Getty Oil (emphasis mine), ``For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips. The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. There are no safeguards that can protect the emotional investor from himself.”

These warnings, instead of generating added public interest towards the market, may prompt for even more aversion on the unwarranted implications that the domestic market is vulnerable to either “gambling” or manipulation. This essentially negates their present efforts (e.g. nationwide roadshows) to boost the demand side in their thrust to advance the cause of enhancing the present state of domestic stock market.

What, I think, needs to be addressed instead, more than just simply issuing inane warnings, is the strict monitoring or surveillance of possible manipulative activities undertaken by cabals or groups intending to hype or corner certain issues. Warnings like these are nothing but bad publicity, yet it actually misses the forest for the trees.

For instance, the PSE glosses over the main drivers of these activities: surplus liquidity! The tidal wave of excessive liquidity throughout the world today has palpably filtered into the local markets through the transmission mechanism of the Philippine currency’s price appreciation. As we have noted previously, a strong peso and declining yields have most likely underpinned these “search for higher returns” phenomenon now manifested via speculative punts. As long as these underlying incentives remain, the trend towards broadbased speculations would likely continue.

Let me divert for a while, in an article, I recalled that the PSE president commented that about only 1% of the Philippine population are invested in the domestic stock market today. 1% of a population of 84 million translates to only about 840,000 individuals! That speaks of how unprogressive and underdeveloped our stock market is. For some to comment that these heightened speculative activities signify a “top” in the market operates on the premises of a lackluster growth of domestic market participants, aside from the presumption that funds circulating within its spheres are limited, which in my view, is highly flawed.

Figure 2: McKinsey Quarterly: Asian Capital Markets

Figure 2 from McKinsey Quarterly is a comparative chart of capital markets of Asia and other select countries around the world. While I extracted this from McKinsey Quarterly’s article about China’s financial markets, the informative expanse of the structural makeup of the region’s capital markets prompted me to include this noteworthy chart in this week’s outlook. It gives us a clue why the Philippines remain at the posterior in terms of economic development.

Except for Japan whose equity markets have been shellacked by a bubble bust down by about 80% from peak to trough, aside from its massive pump priming activities undertaken during its 14 years of economic doldrums which ballooned its debt to about 160% of its GDP, most progressive countries could be observed as having less (or declining) reliance on the traditional sources of funding as banks and governments, while equity markets have contributed significantly to their progress. In the words of market guru George Soros, ``The stock market is one of the most important repositories of collateral”. Yes, we could also see that the corporate debt market could also be one area of growth.

This leads us back to the speculative activities in the market. I have noted of the rising trend in the number of issues traded, where I would theorize that this trend have incorporated new participants and new money into the market, which has provided a flanking support to the largely foreign driven Phisix today.

The local investor base is coming from an extremely low side in terms of penetration level as percentage to the population, ergo if the stronger peso would be able to induce more participation from the domestic investors or even from overseas workers or migrants, let us assume from the present 1% to 5%, you can just imagine the sheer magnitude of support the Phisix would have at its present advance cycle.

That is why I am bullish and would speculate on issue/s that are related to the equity markets itself aside from other possible growth areas in the field of non-traditional finance. Call me a speculator too, in the John Steinbeck (Nobel Prize winner for literature) fashion (emphasis mine) ``I don’t know how speculation got such a bad name, since I know of no forward leap which was not fathered by speculation.”

A Splendid Week For Philippine Assets

``When a thing is done, it's done. Don't look back. Look forward to your next objective.” -General George Marshall, Chief of Staff, US Army

This had been a remarkable week for the Philippine financial markets. Not only seen with the magnificent performance of the Philippine Composite benchmark, the Phisix, but also of the Philippine Peso and the domestic bond instruments.

First, Philippine bonds significantly outperformed its peers to bring down coupon yields in both Peso and dollar based debt instruments to March 2006 levels. This comes as the national government recently announced of its plan to swap its short-term dollar instruments with longer dated issues. The government aims to lengthen its debt maturity profile and to take advantage of favorable market conditions into lowering of its financing costs.

Second, the Philippine currency continued to outshine the region as it surged to a fresh four year high milestone at 50.25 last Wednesday, but closed at 50.49 to a US dollar or .48% higher over the week. Economic growth and portfolio inflows had been attributed to its recent activities, according to Bloomberg’s Clarissa Tan, ``The Philippine economy grew the most in the second quarter in a year, while growth in exports was the quickest in six years. Money from abroad flowing into the nation's stocks helped push the benchmark share index to its highest close this week in more than three months.”

Third, the Phisix was the second best performer in the region up 2.09% following Vietnam’s outstanding 2.98% advance over the week in a rather mixed region. While foreign money, as usual, shored up the domestic bellwether, the intensity of the inflows had been seen mostly diffused throughout index component issues. Issues with over 50million pesos worth of inflows reached the same levels as the Phisix peaked last May or prior to the most recent global selloff, while the positive spread between the inflows and the outflows likewise reached a level seen during the euphoric phase during the second quarter.

Figure 1: Daily Wealth/Stockcharts.com: Large Caps Outperforming

Put bluntly, foreign money appears to have concentrated their accumulation activities not limited to select issues but towards broad-based large market cap Phisix component issues. The shift towards large cap investing could be seen as possible defensive tactical maneuvers which seemingly validates the outlook of a possible moderation of economic growth in the global economy. As shown in Figure 1, the trend towards large caps investing could be a global one as depicted with parallel developments in Wall Street.

More importantly, this week’s buoyant activities comes in the face of a decline in the US equity markets which had been strongly correlated to the world markets, as well as the Phisix, since the second quarter of the year. This seemingly unique divergence, while not to be construed yet as a definitive trend, as one week does not a trend make, could possibly presage on the future outlook for the Phisix. The resiliency of last week’s gains could probably be tested by another bout of global “risk-aversion” activities.

Posen: Faddish Export Promotion Is a Heavy Burden for Any Economy

``Entrepreneurs are simply those who understand that there is little difference between obstacle and opportunity and are able to turn both to their advantage."-Niccolo Machiavelli

Finally, as the Peso has put one into the books following its milestone high, you can expect a hue over these developments as “bad for the economy” in the coming days from various experts who would recommend the “management” or interventionism in the currency.

I pointed in the past that for the longest time the peso has devalued, yet such price mechanism has not worked out favorably to expand our export sector which incidentally despite growing nominally, has been declining based on the rate of growth during the past few years. In essence, the depressed peso has not only lowered the standards of living of the Filipino people, it has not uplifted the export sector to gain a critical mass to improve on our lives. In other words, the export sector’s problem is much more than a factor of price mechanism. As an analogy, if price of labor would be the single most important variable for determining the recent trend of outsourcing investments, then Africa and not China or Asia would be the major beneficiary, considering the mostly politically blighted environment. Again I see this predicament of ours, as a complex product of bungled regulatory policies and extensive interventionism.

I’d like to quote extensively Economist Adam Posen of the Institute for International Economics, in his articulate article, ``Faddish Export Promotion Is a Heavy Burden for Any Economy” for making a good case against Export Promotion (emphasis mine)...

``In spite of the frequently cited examples of export-led growth for some developing countries, there is mounting evidence that the benefits to growth of countries' engagement in trade are attributable to openness. These include the direct benefits of importing lower prices and greater variety; the efficiency gains from challenging (rather than protecting) domestic businesses; and policy choices that contribute to a broadly liberal and market-oriented framework across the economy. Exports taken on their own, the usual narrower target of competitiveness policy, are not correlated with average per capita income growth.

``A focus on export competitiveness usually leads to actively harmful policies, beyond simply wasted resources and rhetoric. If exports are the public criterion of economic success, policymakers can meet that goal only by self-destructive means: depreciating a country's currency, thus eroding the purchasing power and the accumulated wealth of citizens; depressing wages in export sectors, either directly or through relative deflation vis-à-vis trading partners, thus cutting real incomes and domestic demand; subsidizing or protecting exporting companies, thus distorting investment decisions and locking in old technologies and businesses at the expense of new entrants; or promoting national champions, thus increasing both wasteful public spending and the costs to domestic households and businesses.”

Like those who espouse divergent ideas, I believe, that our common goal is to see the best approach for country’s progress, but unlike them, my view is one of the unconventional and unorthodox, and rests on the grounds of personal responsibility to enhance one’s life and that of the society, and not through dependency. By allowing markets to function at its fullest, enterprises should proliferate, baneful politics would be greatly reduced and standards of living would eventually rise. Remembering the battlecry of the late Chinese leader Deng Xiao Peng to open China’s economy to the world, ``to be rich is glorious”.