A Correlation Is A Correlation Until It Isn’t

``We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe nothing's happening...the initial pop seems like a random event until the second occurs. A third. A fourth. Then the popping goes wild."-Richard Bernstein Merrill Lynch chief investment strategist quoted in Time magazine.

There has not been much change in the markets this week since shakedown began at the end of February. For the moment, we still see a semblance of the same variables that appear to be influential forces at work.

Our Phisix was down 1.21% over the week, as global markets appear to be on a downward trek. Our inspirational leaders the US markets have likewise been down, the Dow Jones Industrials lower 1.35%, S&P 500 1.13% and the Nasdaq .62%.

In the meantime, we saw the Japanese Yen significantly higher up 1.19% while the Swiss Franc likewise higher 2.17%. The significance of these currencies as we have mentioned previously is that they have been presumed to have acted as FUNDING currencies for the so-called CARRY TRADE arbitrage, where the yield spreads against the other currency pairs, have been used as leverage to invest into other asset classes. Such has been said to have provided for the gains in the global cross-asset markets via increased liquidity, which has supported risk taking activities.

The recent turn of events has demonstrably been coincidental with the movements of such currencies giving credence to the belief that the CARRY TRADE could have been a significant factor in the recent upsurge in volatility. Declines in equity and credit markets have been simultaneously seen with the ferocious rally in the Funding currencies.

Yet, this phenomenon called the CARRY TRADE has gone against the traditional economic wisdom called “uncovered interest parity” where to quote the Economist (emphasis mine),

``Countries that offer high interest rates should be compensating investors for the risk that their currency will depreciate. In other words, the forward rate should be a good guess of the likely future spot rate.

``In the real world, uncovered interest parity has not applied over the past 25 years or so. A recent academic study has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. Carry-trade strategies would have brought substantial profits, not far short of stockmarket returns, although dealing costs would have limited the size of the bets traders could make.”

In other words, some traditional economic theories as cited above do not seem to apply in today’s rapidly evolving marketplace. Such is the reason why markets may seem so illogical, simply because they act to defy on our beliefs or of past paradigms. Again, the lesson being that past performances does not guarantee future outcomes.

I, for one, while being a skeptic, have observed at this amazing “circumstantial evidence” of correlation, but would not simply write off the possibility or probability of its causal relations with the actions in the financial markets today.

Since the world is undoubtedly extremely leveraged, the carry trade could simply be a part of the growing mechanism to accommodate more leverage.

Nonetheless many analysts, some of whom I highly respect, dismiss on the premises of its correlation based on the lack of direct evidence, in the form of official flows. The Bank of International Settlements (BIS), an international organization of Central Banks, have largely been neutral about this, as evidence have been “mixed” based on global claims as shown in Figure 3.

Figure 3: BIS Tracking the Carry Trade

Claims in Japanese Yen or Swiss Francs have not established any material footprint as with regards to the much touted CARRY TRADE in play. Although the BIS admits that quantifying or measuring the volume of carry trades have been “problematic”, the best evidence they could come up with could be seen via Forex Futures.

According to Patrick McGuire and Christian Upper of BIS, ``Data on open positions in exchange-traded FX futures in potential funding and target currencies provide the strongest evidence for a growth in carry trade activity in recent months. Noncommercial (“speculative”) short positions in yen futures traded in the United States rose between mid-2006 and late February 2007, particularly during periods of yen depreciation (Graph B, righthand panel). By contrast, speculative short positions in the franc yield little evidence of an increase in futures-based carry trades over this period. Data on speculative long positions in FX contracts on the main developed-country target currencies increased considerably in the second half of 2006, but declined somewhat in early 2007 (Graph B, right-hand panel), consistent with the rise and subsequent fall in the carry-to-risk ratio over this period. However, the weekly movements in this ratio appear to explain little of the changes in speculative positions, although the relationship is statistically significant for some currencies”.

As we always say, a correlation is a correlation until it isn’t. While our aim is to distinguish signals from noises, we see correlations as possible clues for signals in determining the future directions, as in the case of the Phisix and the Philippine Peso shown in Figure 4.

Figure 4: Inverse movements of the Phisix and the Peso

The blue arrows above shows of the inflection points of the Peso and coincidentally they have also proven to be counter inflection points for the Phisix, represented by the red arrows. When the Peso declines relative to the US dollar, the Phisix falls vice versa. The correlation seems to have become emergent in 2005.

I have asserted in numerous occasions that portfolio flows at the margins have determined the price variability of the Peso, in contrast to the conventional wisdom that remittances have been its key driver or of other factors suggested by our experts.

If my observations remain valid or cogent, we will see the same patterns unravel as the Phisix corrects or consolidates on the GROUNDS of foreign portfolio outflows on the “reappearance” of global risk aversion.

I believe that markets always convey some latent messages via its price action, so I listen to them and heed their messages instead of trying to “rationalize” or deliver a simplified explanation on their behavior in contrast to our experts or my contemporaries.

My observations of the Peso’s correlation have not been limited to the Phisix but also for Philippine sovereign bonds. In short, circumstantial evidences points to the validity of my theory that the Peso asset classes are set at the margins by portfolio flows.

Figure 5: Asianbondsonline.org: Philippine Sovereign 2 year and 10 year yields

As you can see in Figure 5 courtesy of Asianbondsonline.org, the spike in the Peso over the same rising risk aversion event in May of 2006, simultaneously manifested a jump in the USD relative to the Peso, the decline in the Phisix and equally a jump in yields (falling bond prices) for Philippine sovereign debts.

If I am correct that the countertrend phase is still at work, then the likelihood is that all three markets could show of the same degree of correlation over the interim.

Finally, I still think that today’s market activities are natural cyclical transitions playing out unless proven otherwise. Question is if we are going to see fundamental support for this decline, particularly on the risk of a US recession, this raises the risk of greater degree of volatility.

However, unlike in 2006, today’s shakeout has NOT seen a safe haven rush towards the US dollar. Instead the US dollar, as measured by its Trade weighted Index, continues to swoon even as volatility continues to snowball.

While others argue that emerging markets will drop like a stone if the US goes into a recession, in contrary, I think that the emerging “stagflationary” environment in the US will translate towards further decline in the US dollar and be supportive of the precious metals class and of the emerging markets.

The likelihood is that we will see a departure from presently aligned correlations of ALL market classes with those that thrive under such defined environment.

Following former banker and Citicorp Chairman Walter Wriston’s (1919-2005) principle, ``Money goes where it is wanted and stays where it is well treated”, Asians have treated money well relative to its Anglo-Saxon counterparts and therefore, money flows should be expected to continue.

Hope is A Good Companion But a Poor Guide!

``Risk can be a friend or foe and as an investor you will succeed or fail depending on how you deal with it. Risk is inherent condition of all investments and should be respected, assessed, managed and prudently controlled.”-Ed Easterling of Crestmont Research, Risk is Not a Door Knob

TO some, my words of caution have been viewed as displeasing or unwelcome, as I had been expected to play the role of a perpetual cheerleader for the markets. There are even those of you who think that my views as that of a messenger of doom, a party spoiler. ``Therefore, whoever thinks he is standing secure should take care not to fall.”-Corinthians 10:12

Yet the reality is that parties don’t last. They never do. And betting on unfounded optimism can result to capital losses or mental anguish or a combination of both. As market savant Andy Kessler quotes his friend, ``The stock market trades to inflict the maximum amount of pain”. Pain especially for those who apply vanity to the markets. As we have said before, people get what they deserve.

You have to understand that my sustenance depends on being MAINLY profitable, which means reading, analyzing and acting right. Even when we maintain certain convictions, we certainly avoid from FIGHTING THE TAPE because previous experiences tell us that doing so leads to emotionally wrenching losses. Instead, we treat the trend as our friend. And even among hardcore chartists, they will tell you that markets are rangebound 80% of time and trends only 20%.

While we may not be always precise, we can consistently be profitable for as long as we principally act to PRESERVE our capital. And in doing so, we bank on the wisdom of Aesop’s principle with the foremost question in mind, is the bird in the hand is worth more than two in the bush?

Yes, our market operates in a juvenile state, such that it has been a ONE WAY street for investors; one can only earn from consolidating or advancing markets. When the cycle turns, all our investors can do is to sit on the sidelines and wait. Having said so, our fate depends on these conditions unless hedging facilities do come on stream. To my knowledge, hedging facilities such as short trades or the development of the option markets are still on the design boards yet [shorting may come soon].

In my case, I have made use of the advancement of technology and globalization trends to position on the overseas markets, particularly on Asian markets, as to diminish my home bias [expand my country risk profile] and reduce my dependence on the developments in the local markets.

In the aftermath of the recent tremors in the global markets, the bulls have been quick to respond with the conviction that the recent drop would be quick one, where like a storm, would be gotten over with soon. I do hope so too. But as Mark and Jonathan Finn of the Vantage group says ``HOPE is a good companion but a poor guide”.

Phisix: Market Indicators Suggests for Further Corrections

``Markets are cyclical – always and forever. As share prices oscillate between lofty valuations and lowly ones, investor perceptions oscillate between greed and fear. When investors are fearful, they demand a large margin of safety from the assets they buy. But when they are fearless, they worry less about safety than an intoxicated teenager.-Eric Fry, Whack-A-Risk Rude Awakening

Figure 1: Corrective Phases of the Phisix

Judging from past experience of if one would use past data to extrapolate on the future, the shortest corrective phase of the Phisix since 2002, was in 3 months, i.e. October 2004 to January 2005, as shown in Figure 1.

The end of the corrective cycle is determined by its breakout from its previous high. The numbers indicated in the chart shows of the months it took for the Phisix to eventually supersede its previous highs.

As you would notice, one of the core pillars of my analysis has been anchored on the understanding of market cycles, where market cycles are principally determined by psychology as previously defined. And the present market cycle implies that the corrective phase is a natural phenomenon.

Since the start of the cyclical reversal in 2003, declines as measured by peak to troughs had an average period of about 2 months, where if applied to the current settings (topped at February 21) would possibly translate to a trough sometime latter April. (That’s IF the cycle plays out as in the past! But what if HOPE or the bulls are right?) The rest of the months which follows the trough represents as the healing phase or a period of consolidation segueing into gradual ascendance.

There is also the seasonality factor. You’ve probably heard of the axiom “Sell in May and Go Away”. While this may not always hold true, it simply implies that the seasonal periods of May [50:50 for May-June in a span of 22 years] heading towards the third quarter COULD be the weakest link for stock performance.

In other words, based on cyclical and seasonal factors alone, the odds for a short-term massive comeback looks obscure, or your two birds in the bush in exchange for the present one comes with significant obstacles.

Yet this does not even consider the degree of the upside gains relative to its possible percentages retracement.

If one were to use the Fibonacci figures, based last July’s trough until the peak of February 21 as possible indicators, the levels of retracement are at 2,890 (38.2%), 2,750 (50%) and 2,550 (61.8%). Pardon me for practicing financial astrology [in accordance to Benoit Mandelbroit’s thoughts on chart reading] here. So far the Phisix has yet to reach any of these natural retracement or fallback levels which may suggests of further room for retracements.

Question is, with the current developments and at present levels is it worth the risk to underwrite?

US Markets: Risks of Ponzi and Speculative Finance

``Liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets".-Albert Edwards "Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity", Dresdner Kleinwort Global Strategy Report

One could always argue to say that since the Phisix has been inspired by global markets, particularly the US benchmark Dow Jones Industrials, wouldn’t it be more practical to compare the directional path of the Phisix to its developed market counterparts? Let’s see.

First, speaking of risks, I’d like to first borrow PIMCO’s Paul McCulley quote of the Hyman Minsky, the father of the Financial Instability Hypothesis, where the transitory structure of the credit markets shifts from one marked by stability to another which eventually destabilizes. The Financial Instability Hypothesis was first articulated in 1974 but published in 1991, whose excerpt is quite academic yet I think presents as the real menace to today’s finance-driven economies (emphasis mine)...

``Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

``It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

``In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Evidence shows that “Modern Finance” has been underpinned by such transformations into the above “speculative finance” and “ponzi” spheres, such as the proliferation of “structured finance”, derivatives, and other innovative financial products.

Some hedge funds are even said to have employed by as much as 50 times leverage relative to its capital, where a 2% decline in the securities invested would effectively translate to complete or 100% capital loss! In other words, the ocean of credit creation and intermediation has led to diminished returns, more risk undertaking, narrower spreads and the seeming ambiance of low volatility, where in true dimension reveal nothing more than inflationary manifestations accommodated by the global governments. Such processes are natural offshoots to the order of Paper or Fiat money standards.

I was recently asked of what I thought would be the probable effect of former Fed Chief Alan Greenspan’s pronouncement that the US had ``one-third probability'' of a U.S. recession this year. Further, Mr. Greenspan likewise noted that the current expansion won’t have the same degree of endurance compared to its decade long predecessor, quoting Mr. Greenspan ``Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter' and is likely to be this time”.

While my reply was to essentially heed the signals of the different markets, my humble opinion is that it would be better for the US to undergo such adjustment process for country to be able to cleanse the excesses built into the system.

In exchange for short term turbulence would be gains on a sounder footing over the longer term. Does it not follow in the context of economic cycles that the next phase after recession would be a recovery? So what is so bad with a recession?

Although my main concern has NOT been that of a technical US recession, but of a possible implosion of leverage that could affect the entire global financial and monetary structure and cancel out the present gains in the system.

Figure 2: Casey Research: Exploding Derivatives

Figure 2 from Doug Casey shows of the exponential growth of OTC derivatives, one of the potential epicenters for the markets’ dislocation, quoting Mr. Doug Casey (emphasis mine),

``The collective result is that our financial system has been wired up to $370 trillion dollars of privately negotiated investment contracts. They’re usually written to shift risk from one bank, pension fund, insurance company or brokerage firm to another. And many are linked together in long chains, with each contract providing collateral for the next.

``It’s all very clever, but layering the enormous size– $370 trillion dollars, far more than the net worth of all the financial institutions in the world – on top of all that complexity is downright scary. In simpler times, a home loan going bad would affect only the particular lender. Enough defaults would put the lender out of business. And that would be the end of it. But today a wave of defaults can send a shock through the portfolios of financial institutions around the globe, including hedge funds, banks and pension funds far removed from the troubled borrowers.”

Yet the optimism exuded by the bulls have been premised on the notion of a BERNANKE PUT, where the FED or the Working Group of Financial Markets a.k.a. Plunge Protection Team would intervene and provide for the liquidity of last resorts to the finance driven US economy.

For instance, Jeremy Siegel of Wharton in his interview debunks risks of emanating from hedge funds (emphasis mine), ``Could they precipitate a crisis? Not with the Fed on top of it. The Fed can diffuse any crisis. If everyone gets on one side of the market and things are out of control, the Fed is the ultimate source of liquidity. I think that they can prevent that from spinning out of control. So at this particular point, let people follow those paths that they think are most profitable.”

There are those who claim that the US government would not step in to the rescue of the US economy as evidenced by its non-intervention in the ongoing subprime woes. Past actions have not been substantiated by this claim, namely the S&L crisis, Tequila Crisis, Asian Financial Crisis, Russia Crisis, Y2K jitters, the most recent Dotcom bust or 9-11, where the FED responded with liquidity injections.

These actions by the FED have in fact spawned the overconfidence and increased risk taking appetite as denoted through by Mr. Siegel’s comments that governments are always there to cushion investors from the market’s volatilities. And reading through the present action, the recent ruckus in the markets has NOT BEEN SIGNIFICANT enough to openly prompt for any action from the FED YET (they are still quibbling about inflation!).

Whereas even if FED were to intervene both Mr. Paul McCulley of PIMCO and David Rosenberg of Merrill Lynch suggests that such meddling would be least potent or would not have much significance to mitigate on the effects of the ongoing hemorrhage in the housing industry.

In the astute words of Paul McCulley (emphasis mine), ``It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.”

From Merrill Lynch’s David Rosenberg as quoted by the Daily Reckoning (emphasis mine), ``“What drove the housing-led cycle was not as much the cost of credit, but rather the widespread availability of credit - irrespective of your FICO score [a measure of your ability to repay]...only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

In other words, the bleeding in the housing industry would not be stanched by the prospective FED intervention by the lowering of interest rates, from which the financial markets have mostly priced in their gains from. Both expect the housing woes to diffuse into the greater segment of the economy, which enhances the risks of a greater- than-expected slowdown.

Another example of Ponzi-derived leverage is the YEN Carry arbitrage. While some analysts have debunked the extent of its influence due to lack of concrete evidences from official fund flows, the coincidental effects manifested by the movements of the Japanese Yen and the global markets have been simply so compelling to dismiss.

Figure 3: Stockcharts.com: Overblown Carry Trade?

In figure 3, the initial impact of the Yen’s (superimposed line chart) surge coincided with the tremors in the global equity markets represented by the Dow Jones Industrial Averages (candlestick) and the Dow Jones World Index (lower pane) as shown by the blue arrows. Last week’s steep selloff in the Yen have likewise mirrored the rally in the Global markets (green arrows).

Many argue that macro factors as demographics (aging population seeking higher returns), as well as micro fundamentals as the tentative growth outlook have not been supportive of a sustained rally in the Yen.

Figure 4: John Murphy: The YEN on MAJOR SUPPORT

According to the Economist quoted last February, the Japanese Yen has been undervalued by 28% (!) against the US dollar based on the Big Mac Index and 40% (!) undervalued against the Euro, making it the world’s most inexpensive major currency!

As figure 4 from John Murphy of stockcharts.com shows, the Yen sits on massive multi-year support levels seen in the EURO (left window) and the US dollar (right window). Testing critical support levels of this nature could be expected to incur violent reactions of which we had earlier witnessed. Nonetheless, the YEN on both pairs have been extremely oversold and should naturally begin its ascent.

What significance does this imply to global markets? If the camp of analysts who claim that the YEN trade has not been a major factor in the recent carnage are right, then we could expect the financial markets to simply shrug off any potential rise in the Yen as it bounces of the major support area.

On the other hand, if what we observed would continue to dictate on the market’s interim actions then a rising yen could UPSET any actions initiated by the bulls which would imply for more selling pressures.

Figure 5: Economist: Reintroduction of Risks

The global contagion has reintroduced the concept of risk where it has once been thought to have gone into hibernation as shown by Figure 5 from the Economist.

Figure 6: Northern Trust: Corporate Equities: Supplies go Down, Price Rises

If you think all the tremendous money and credit generated and distributed had been channeled to “productive” investments, Figure 6 from Northern Trust reveals that the recent winning streak in the financial markets have been likewise due to the massive “retirement” in the supply side of equities emanating mostly from the idle surplus capital from corporations and private equity deals.

According to Paul Kariel of Northern Trust (emphasis mine), ``As one can see, a record $548 billion of equities were “retired” in 2006. This is not only a record retirement in dollar terms but also a record relative to nominal GDP. Rather than engaging in a capital spending boom with their recent profit largesse, corporations have been buying back their publicly-traded equity shares with abandon. In addition, the surge in private equity activity has retired shares. So, with the record contraction in the supply (in flow terms) of shares, is it any wonder that the price of shares rose last year?”

Yet Mr. Kasriel further notes that foreign buying has mainly been providing support to these share “retirements” while at the same time HOUSEHOLDs directly or indirectly have used this to finance consumption in place of a slowing mortgage equity withdrawal.

The problem is that as the housing woes deepens, source of funding for US consumers becomes more strained unless they curb their spending patterns and or grow their income faster and or the clip of supply side “retirements” accelerate and or discover other alternative sources for liquidity generation (possibly more debt). This anew poses as another variable which may present itself as more risk to the bullish premises.

The dynamics of share “retirements” or buybacks by corporations coupled with record amounts of insider selling prior to the recent selloffs can be viewed as circumstantial evidences in the light of non-productive investments in support of a privileged few. The growing income inequality gap in the US is nonetheless a manifestation of the continuing “Monetary” inflation policies and the unsound practices of the present Paper based money system.

Finally, whether the recent tumult was due to the Japanese yen, dislocation brought about by unwinding leverage, escalation of mortgage woes, decelerating earnings growth, reversal of expected “liquidity of last resort” or the “Bernanke Put” from the Fed or the lack of continued support from foreigners on the supply side of the equities equation or questions on the sustainability of debt driven consumption or inverted yield curve or the much loathed “R” word-whose probabilities appears increasing by the day, all these points to the horizon where the markets looks increasingly tilted towards heightened volatility going into the interim future.

Risk only amounts you can sleep on; buy on panics and do tighten your stops.

Phisix: Playing Out Our Script

``Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success.'' –Warren Buffett

Finally, the market plays out our long and much awaited script!

While it may be close to impossible to determine such timing with pinpoint precision, market CYCLES eventually PREVAIL.

We had earlier described the local market as “knocking” on history’s door based on the bullish momentum in an attempt to crossover the resistance level. We also observed that budding speculative fervor from within represented risks of EUPHORIA, where similar circumstances in the past alluded to imminent TOPS. [The Phisix fell 7.35% over the week!]

We also discussed of the extreme bullishness as not being confined to the premises of the domestic arena and that the pervasive winning streak in global equities has led to similar sentimental buoyancies here and abroad. We even cited China and Vietnam experience as examples of a brewing “mania”. [China fell 9.2% in a single day!]

If there is any one indispensable lesson from this week’s activities, it is that WORLD dynamics and NOT local events have now proven to be the major determinants of the directional paths of our market, in stark contrast to what has been long promoted by our “experts” and the media. FINANCIAL GLOBALIZATION has been its KEY catalyst, where as described over and over again, as with the shared benefits comes with it the risks of contagion. [World markets from the Americas, EUROPE, Asia and MENA regions have taken a beating!]

Moreover, because of the growing significance of the asset markets in shaping today’s “finance-based” economies, governments have been sensitive to such developments and have attempted to extend CONTROL, which has lead to UNINTENDED consequences. Last week’s “Shanghai Surprise” as some market pundits call it, a crash which resonated around the world, and previously in Thailand serves as concrete examples.

Lastly, as also described in the past, RANDOMNESS, or aptly known as “Black Swan” or HIGH SIGMA standard deviation or “FAT Tail” [low probability but high impact-events], applies to the market beyond the confines of any sophisticated high tech mathematical or chart models. Here, past actions have failed to determine future activities. [There is much surprise to the markets than we are wont to believe.]

The Blame is on China’s “Shanghai Surprise”, But....

``Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” -- George Soros

MEDIA has been plastered with reports that China’s “Shanghai Surprise” was the culprit to last week’s highly volatile activities worldwide. Nonetheless, the public including many analysts openly embraced such supposition.

As a disciple of the market, we try to keep in mind the premises of Frederic Bastiat’s theory; “That which is Seen and that which is UNSEEN” or the parable of the Broken Window. The theory essentially deals with OPPORTUNITY COSTS.

What is SEEN today is that CHINA’s crash virtually CAUSED the maelstrom in the global financial markets last week.

While it may be true that the initial tremors in the global markets have been staged at China, the predicated causality is very much in doubt. In other words, I do not share what I perceive as a logical fallacy POST HOC ERGO PROPTER HOC “after this, therefore because of this” as espoused by the mainstream.

Figure 1: Bloomberg: Shanghai Composite: Not The First Time!

The market usually responds to a shock violently. But, in the case of China, this is clearly not the first time! Morever, the last shock happened in less than a month’s period!

In Figure 1, courtesy of Bloomberg, China’s bourses have come under siege from its authorities trying to rein in the “bubble-like” phenomenon in its equities market.

In late January of this year, according to a Forbes report, ``Cheng Siwei, vice-chairman of the National People's Congress, warned investors not to engage in speculative activity in the stockmarket because of the risk of a bubble developing and bursting, causing heavy losses, the Financial News reported.”

The warning allegedly contributed to a harrowing one day 6.5% decline as exhibited by the red arrow on both the Shanghai and Shenzhen bourses. Yet, the world has basically ignored such happenstance.

Could this suggest that since the world discounted the earlier drop, that the bigger magnitude (9.2% on Tuesday) had more of an impact to trigger a domino effect? I doubt so.

Second, one must be reminded that China’s financial markets are severely constrained by choking government regulations, where both domestic and foreign investors have limited options. Edmund Harriss of Guinness Atkinson describes best the conditions from Ground Zero (emphasis mine),

``The Chinese stock markets are in reality very thin in terms of market participants. In spite of the huge numbers of brokerage accounts a small number of funds, companies and high net worth individuals dominate the market. And they invest on the basis of Technical Analysis (i.e. price patterns) and News Flow, not on Valuations.

``The markets are also ring fenced by China’s closed capital account that means there is no general freedom to move money in and out of the Yuan or in and out of the country. Foreign investors are allowed into the domestic market but on highly restrictive terms and local investors are not allowed to go outside except on highly restrictive terms.

``So local investors don’t really have a choice. Or they do, but not a very attractive one. They can invest their money in bank deposits which will pay 2.52% for a one year deposit; or they can buy a 2.5% guaranteed return product from an insurance company; or they might invest in government bonds that currently yield under 2.65% for the ten-year, if they can get them. No wonder that when they see a hot thing they are on to it.

``But this means that Chinese stock markets do not adequately reflect local economic conditions, in our opinion and therefore should not be used to predict global ones. High volatility and high valuations are part and parcel of inadequately functioning stock markets.”

In an interview at Bloomberg, the illustrious veteran Mark Mobius of the Templeton fund basically shares the same view that China’s market is overvalued whose present activities shows disconnect from economic realities. Mr. Mobius thinks that China’s bourses will continue to suffer from selling pressures over the interim.

Figure 2: LA Times: Tail Wags the Dog?

Third, it is important to note that for a domino effect to take place means having a significant correlation on certain variable/s. In this case the connecting factor should be accessibility of foreign money to China’s equity assets. Yet, Mr. Harriss mentions that investments from foreign investors are as limited. LA Times estimates that these accounts for less than 3% of its market value.

Theglobeandmail.com quotes Arthur Kroeber, director of Dragonomics Research in Beijing in estimating the size and depth of the Chinese market, ``Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares...Only about $400-billion worth of shares can be legally traded now, and of this amount, only about $160-billion are held by retail or institutional investors.”

Globeandmail.com continues (emphasis mine), ``This means that 60 per cent of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status.”

This brings us to question on the foundations of the “China-driven contagion”; how SIGNIFICANT can it be for China’s $400 billion worth of tradeable shares or even less (remember 60% held by the ruling class) or $1.3 trillion of market cap [representing a measly 2.2% of the aggregate global market cap, see figure 2] to severely AFFECT a northward $70 trillion in world market cap?

The corollary is to suggest that Philippine market’s crash (market cap about US $80+ billion) CAUSED the carnage of the China’s bourse. How awkward can such reasoning be!

While I am seeing a sea of blood across the world’s bourses following Tuesday’s selloff, it is noteworthy to observe that Vietnam has been entirely unscathed and continues to race upwards with an amazing 5.95% advance over the week! In other words, because Vietnam’s stock market has a similar construct to that of China, i.e. restricted foreign investments, it has been less susceptible to global capital flow dynamics and relies on domestic developments as its main driver.

Remember in this age of digitalization, we are talking about global money flows at the click of a mouse. It is worth repeating that while China’s market cap is ONLY US$1.3 trillion, where about $200 billion is essentially exposed to the public or could be owned by foreign money! In contrast, our domestic market has been dictated by foreign money accounting for more than HALF of its turnover since the cycle reversed in 2003. This subjects us to the shared risks and benefits of a globalized market.

In addition, China’s loss of ten percent (10%) in nominal terms is equivalent to only US$ 130 billion, in contrast to the aggregate US market cap, which at an estimated US $27 trillion (NYSE, AMEX, Nasdaq et. al.), lost US $810 billion or 3% (rounded off) or about two-thirds of China’s market cap! So which do you think is suppose to have a larger impact on global markets?

Fourth, while it is said that the new rules imposed by the Chinese authorities aimed at curbing rampant speculation as being responsible for the carnage, this seemed to have a belated effect. According to Barry Ritholtz (emphasis mine),

``China's Shanghai and Shenzhen stock exchanges issued on Sunday the new rules of regulating their member securities companies in a bid to ward off risks in stock trading. The rules, which will come into effect on May 1, set limits to the varieties, methods and scales of stock trading that dealers are allowed to conduct, preventing them from engaging in high-risk business beyond their capacity.

``Note that these details were released on Sunday, and on Monday Chinese markets set new all-time record highs! Indeed, despite recent official discussions of new capital gains taxes, increased regulation and the government's desire to reduce speculation in China, their indices had advanced 13% in the prior six sessions -- all setting records.”

Where markets are supposed to react to new information supplied, a seemingly belated effect implies detached reality. In other words, China’s market fell NOT on the NEW rules but on some other underlying UNSEEN factors.

With the snowballing signs of mania, where people have now been borrowing against their homes to gamble or “dubo ji,” or the slot machine, as the New Times calls it, on the stock markets, the government perhaps or probably made use of their sizeable ownership of listed companies to douse on the brewing irrational exuberance by dumping their shares.

Why? Perhaps for political survival, Morgan Stanley’s Stephen Roach thinks that the present leadership views market intervention as part of measures to stabilize the situation, he writes (emphasis mine), ``In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system.”

In short, for investors, it is hard to earn on markets where the APPARATCHIKS DECIDES TO PLAY GOD!

Anyway, I don’t think much of the market actions in China would diffuse into its economy or translate to a consumer crisis, considering that only about 8% of the household assets as estimated by the Mr. Harrisss of Guinness Atkinson are exposed to equities (76% in bank deposits, 9% bonds, 7% insurance). You’d have to look elsewhere for a compelling case that could trigger a “domino effect”.

For all its worth, I believe that the global markets have simply used the “Shanghai Surprise” incident as merely a scapegoat for something much deeper, yet the public has warmly accepted such logical fallacies as “truths”.

Forget China, Circumstantial Evidences Reveal the Unwinding of Carry Trades

In the US, there have been numerous “rationalizations” floated as the reasons for the current “shock” or the reappearance of volatility.

Some attributed it to the comments of former Fed chief Alan Greenspan who uttered the “R” word on Monday in a business conference in Hong Kong in front of group of private investors. Because Mr. Greenspan possibly felt that he may have influenced the recent activities, he quickly clarified his position on Thursday saying that, as quoted in Bloomberg, ``By the end of the year, there is a possibility, but not a probability, of the U.S. moving into a recession.”

Like our previous observations, Greenspan noted of the legions of risks that have been dismissed by the cheerful consensus, where according to the same report by Bloomberg, ``Current low yield premiums aren't sustainable, profit margins are peaking and the U.S. growth cycle is in a mature phase, Greenspan said today. The former Fed chairman said previous experience suggests a flattening of profit margins should produce a recession.”

There are also reports that technical glitches in the Dow Jones Indices helped exacerbate Tuesday’s biggest decline since 2003.

Of course, I don’t buy these myths, analyst Barry Ritholtz aptly wrote to debunk every bit such “rationalizations” in his article the “10 myths in Tuesday’s Correction” whose conclusions I would share (emphasize mine),

``Since the summer, the rampaging bulls have had their way with just about every market on earth. Volatility had been subdued and risks ignored.

``That era is likely over now. Indeed, the general commentary ("buy the dip, hold for the long term") may be ignoring a developing shift in psychology. It reeks of complacency.

``In a note to clients after the plunge, we said to expect three things:

1) Increased volatility;

2) attempt(s) to return to prior market highs;

3) deeply oversold conditions that will eventually create great entry points.”

Now moving to the UNSEEN, here we have one phenomenon that appears to have taken place coincidentally, as the market soldoff. It is something that we have prominently discussed in the past and the issue is no less than the CARRY Trade.

Figure 3: Stockcharts.com: Unwinding Carry Trades? The Funding Currencies

Two funding currencies or currencies arbitraged to finance investments in other asset markets, the Swiss Franc (lower pane) and the Japanese Yen (superimposed) rallied furiously as global markets were sold down the drain, the Swiss Franc was up 1.36% (w-o-w) while the Japanese Yen soared 3.73%. Since the world markets have essentially been highly correlated with the US benchmarks, I placed the Dow Jones Industrial Averages as representative (candlestick).

Figure 3, tells us that the rally has been simultaneous in terms of timeframe [blue arrows] and correlated in terms of magnitude [degree of rallies of the Yen inverse to the degree of decline in invested assets.].

Figure 4: Stockcharts.com: Unwinding Carry Trades? The Invested Assets/Currencies

In Figure 4, the invested asset/currencies which benefited mostly from the Carry Trade, the South African Rand (upper window) and the Australian Dollar (lower window), as well as the emerging Market MSCI benchmark (center chart) have likewise shown a replication of activities albeit on an inverse scale relative to timeframe and magnitude.

Put differently, while there have been incessant blathers about what’s driving today’s markets, it looks as if the dynamics of the unwinding of the Carry trade similar to May of 2006 has played a big PART among the variables involved, as the circumstantial evidence above suggests. The US and the world markets appear to be at the short end of the unraveling of the Carry Trade.

And this is not without precedent, Mike Larson of Money and Markets, ``It’s happened before, most notably during hedge fund Long Term Capital Management’s (LTCM) meltdown in 1998. The yen surged 9% in a matter of weeks that summer, then skyrocketed another 12% in just 72 hours!” Déjà vu?

However, I wouldn’t venture into justifying these as the CAUSAL factors lest be accused of another logical fallacy Cum Hoc, Ergo Propter Hoc” [With this, therefore because of this]. We will have to see if the trend continues to play out in the following weeks.

A Bird At Hand is Worth Two in The Bush

The recent reemergence of volatility has interposed the question on whether this has simply been a respite or a much needed correction for a continued upside move or a pivotal turnaround or reversal. Since the Philippine markets have been largely influenced by the actions in US equities we then would take a clue on the latter’s prospects.

Mr. Adam Lass, Senior Market Analyst, WaveStrength Options Weekly chronicles how the Dow Jones behaved when it dropped 5% in the past.

Quoting Mr. Lass (emphasis mine), ``The largest episodic loss was March-October 2002’s 32.57%, while the smallest was August-October 2005’s 5.25%. The average for all 15 retracements was 15.01%, four were less than 10%, eight were between 10% and 20%, and three were more than 20%.

``So what does this tell us about where the market could be headed next? During the current drop, the Dow has fallen as much as 5.75%. Of the past 15 similar drops, only one time during the August-October 2005 drop, did losses stop at this level.

``Time-wise, the average duration of a fall is 2.53 months and the average latency period from the end of one drop to the beginning of the next is 5.4 months.

In other words, the probability looks tilted towards a continuity of heightened volatility. Only 6.67% (1/15) of the time did the correction stop at this level, while the average may see a decline of about 15%. For as long as the Phisix gets its vitality from the actions of the US markets, we could probably encounter a similar degree of market activity where the risk reward trade off seems to favor more of the downside.

Whether today’s decline is fundamentally supported or not, developments have yet to clear itself, meaning greater uncertainties tend to produce higher volatilities.

Where the path of least resistance is obviously on a downside move, except for US treasuries, a large swathe of the asset classes remain under pressure, surprisingly including the US dollar (I mean the US dollar index) and gold. I think, as the Phisix and the other Philippine asset classes remains under pressure, the Peso will reflect similar circumstances [My hunch is that the Peso could rally to around 51 before reassuming its uptrend].

It pays to probably be prudent by lightening up or underweighting one’s portfolio. And take OVERSOLD opportunities in the market to either load up and trade over the short-term or accumulate for the longer period, as we remain bullish over the longer trend cycle BARRING a global depression. To quote the oracle in Aesop ``a bird at hand is worth two in the bush”.

Ignoring Black Swans and Market Cycles

``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability." Nassim Nicholas Taleb

I find it odd when local authorities come to defend the market as if they can actually move or change the direction of the markets or reverse a cycle on their sheer pronouncements.

In response to the market’s carnage, I read a government official saying that the selloff was an “overreaction” and “did not reflect the fundamentals”. How I wish they were singing the same tune in 2002.

In another article, a press conference of key market participants were quick to point out that low interest rates, cheap valuations, the country’s improving fiscal position, sanguine economic and corporate prospects plus slew of IPOs and buzzing corporate activities as potential catalyst to the market’s rebound.

Yet unknown to many, most of the grounds cited have been based on recent actions. Yes, present conditions have been extrapolated to project future outcomes, in the face of a “shock”. By shock I mean the unexpected contagion effect experienced our financial markets last week.

Take for example low interest rates and inflation; the deluge of money flows from remittances and portfolio and direct investments have been mainly responsible for these.

Portfolio investment at the margins as I have interminably argued has driven the Peso to record highs.

And the global phenomenon of money chasing for expanded yields have caused Philippine bonds to rally vigorously whose spreads with US treasuries have been at record lows. These essentially constitute the key factors that have brought down interest rates, aside from the appreciating Peso which has contributed to the decline of consumer “inflation” rates.

In addition, in the corporate field, 14 companies are lined up for this year’s scheduled IPOs while corporate activities have been abuzz, mostly because of the impressive performance of the Phisix as well as the market’s warm reception to the most recent IPOs.

Now think of what happens if portfolio flows reverse? The Peso will decline which should lead to higher interest rates and rising pressure on the consumer “price” inflation front.

If the Phisix continues to drop then many of these corporate activities could be deferred or shelved until a better time, and so as with the other corporate activities.

In other words, the scenario painted our experts will radically change. Yet, it is a public spectacle to see them use past performance in order to defend present conditions in the face of an unexpected or random events. They appear like political demagogues campaigning in today’s election season.

You have to understand that market cycles are simply an outcome of psychological transformations. First there is the “shock” or disbelief phase, then the denial phase and finally the capitulation phase.

In 2002, no one wanted to touch the market simply because it had been agonizingly in decline for several years. It marked the capitulation for the bulls which signified the start of the cyclical reversal.

In 2003, the market began its upside cycle as foreign money drove the index higher. Political jitters, which in the past comprised as a major hurdle, were simply ignored by foreign capital which continued to pile on our asset markets. Yet, many local investors remain in denial over this period.

And as the trend gets more entrenched and under the backdrop of the steep advances of 2006-7, many local investors succumbed to the rising tide, and commenced upon entering the market, in view that the prevailing trend will last.

Today, the chorus is that the Philippines is on a mend, viewed under the premises of the rising asset class, and as such declare the continuity of the present micro trends. Slowly but surely we seem to be entering the next phase of the cycle; bearish capitulation.

Most, however, continue to ignore the fact that macro drivers have been responsible for these advances, and when the macro factors turns against us, you’d likely see an interim reversal of the present activities. Last week appears to be our proof; the market and the Peso tumbled significantly.

Yet the macro developments could also be a function of the transitional cyclical phases of the world markets, where big price fluctuations are a natural phenomenon.

In a study by MIT economists, evidences has been produced that such outcomes have been periodical. According to analyst Mark Hulbert (emphasis mine), ``Their study, published several years ago in the prestigious scientific journal Nature, reports that large daily fluctuations in the stock market occur, on average, at very predictable frequencies. Instead of seeing these fluctuations as abnormal, the academics' theory suggests we see them as inherent features of the stock market's volatility.

``The study's authors derive a complex model that predicts how often declines of Tuesday's magnitude -- 3.3% in the Dow industrials -- will occur. Over many years, according to that theory, they should occur an average of every five to six months.”

Yes, the recent market action appears to be INITIALLY a cyclical behavior in response to an overheated market worldwide, since trends don’t move in linear fashion.

As I wrote a favorite client, ``But who would accept such explanation? Would you? There has always to be some reason/s. And that is where media loves to feed on...simplistic thinking; which will be what most of the investing public would be willing to digest, including your favorite sources of information.”

In a similar tone I found this very noteworthy quote from the Mr. Black Swan himself Mr. Nassim Nicholas Taleb from his soon-to-be-published book The Black Swan: The Impact of the Highly Improbable, ``Our minds are ... capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability."

Until we see further evidences that support the recent declines as fundamental [macro] based then it would best to treat today’s retreat as simply “inherent features of stock market’s volatility” or cyclical phases of markets.

Lastly, avoid from accepting pabulums premised on past performances, because as the markets have shown last week, Black Swans exists!

Epicenter China? The Return of Volatility on an Unwinding Yen Carry?

China stocks tumbled the most in 10 years! Global indices seem to be feeling tremor while at the same time the Yen rallies across the board! Are we seeing the return of volatility via an unwinding YEN CARRY or is this merely a head fake? We'll see.

Gold Watch: Gold Breaks Out in Yen!

We have been bullish on gold premised mostly on the flawed structural conditions of the global monetary system. Where no country wants to have a strong currency, gold flourishes as neutral currency against these circumstances.

As such, gold’s rise has not been solely against the US dollar but against all major currencies. Gold's performance against key currencies during the past two years in the table above borrowed from one of my favorite analyst John Maudlin.

The latest rebound of gold in the US dollar is also a worldwide phenomenon, and thanks to Fullermoney.com, we may have a clue on where gold maybe headed for. According to Fullermoney.com, ``This is the first breakout against a reserve currency following the May-June 2006 correction.” Yes, Gold prices breaks out in Yen prices! Will Gold in US dollar follow suit?