Another Bullseye! The Phisix Weaves Into A New Frontier.

``Elections are won by men and women chiefly because most people vote against somebody rather than for somebody.”-Franklin Pierce Adams (1881-1960) American Journalist

SO it’s all splashed over the headlines; the Phisix has finally joined its peers (global bourses) to set a fresh milestone high!

Yet, against the conventional wisdom where elections have been thought of as a menace to the markets, we unequivocally asserted that given the today’s credit-driven inflationary environment, political exercises would have minimal consequences to our financial markets.

The Election Drivel

In our January 22 to 28 edition article, Financial Globalization and Not Elections Will Determine the Path of the Phisix we said,

``Unless political developments would have an impact on the capital flow framework as that of Venezuela or Thailand, they are unlikely to MATERIALLY affect the capital flow dynamics on our financial asset markets today. Hence, under such premises, the political election like in the past will most likely be discounted.”

And no matter how media in cahoots with mainstream analysts portrays markets as being event-driven, the fact is that trends, and not events (unless it comes on a complete surprise or shall we say “shocks”) largely determine the market’s activities.

Take for instance the assertion that the markets “cheered” the elections or that “peace dividends” have equally caused the market’s elation.

Figure 1: stockcharts.com: Phisix on a CHEER mode since March!

THE week prior to the election proper, the Phisix had already climbed by 2.6% which essentially confirmed our “election spending” theory.

Here we conjectured that the lagging performance of the Philippine benchmark, which had been be traced to local selling, could have been a direct or indirect result of campaign fund raising via the stock market. Hence, if such activities have indeed weighed on the markets, in spite of discordant behavior of the other Philippine asset classes, i.e. firming Peso and the rallying bonds, aside from the buoyant asset classes of our neighbors of the US markets, the Philippine Stock Exchange (PSE) would recover at the eve of the campaign raising. AND IT DID SO!

If we take a gander at Figure 1, the Phisix is limned on an upside “cheering” mode even PRIOR to the elections. POST-elections simply AMPLIFIED such trend with a breakout gap from February’s high on Tuesday (the Day AFTER), and carved a fresh record at the week’s close.

To quote Sherlock Holmes in the crime novel “The Hound of the Baskervilles” ``The world is full of obvious things which nobody by any chance ever observes."

Furthermore, we argued that in a declining trend of the US dollar, foreign money would likely buttress our markets.

Over the past TWO weeks, where the Phisix climbed by an amazing 5.2%, foreign money flows heavily streamed into Philippine equity assets accounting for Php 5.224 billion or about 11% of the aggregate turnover. Moreover, the scale of influx was seen over the broadmarket, which essentially confirms our outlook that the fate of the US dollar has been a key pillar to global money flows.

As we have said before, media loves sensationalism because it has to sell what the public wants. Such is the reason too why market actions are explained away simplistically, where our “experts” join in to add “authority” on the subject matter even if premised on tenuous grounds. This is because, as mathematician author Nassim Taleb says, ``We favor the visible, the embedded, the personal, the narrated, the tangible. We scorn the abstract.”

Because market actions are oversimplified, what would have been the explanation if the markets fell after elections? “Disappointed by election results”, perhaps?

Now, if one considers the elections as the MAIN driver of our financial markets, would an opposition dominated Senate be favorable to the nation’s present political environment? Could it not translate to even more political tumult and instability rather than harmony? Or could it be indicative of an aggravated gridlock, where legislative activities would grind to halt? (I know; they appear to function more as a body of inquisition rather than of legislation, which provides its members ample room for political “showmanship”….or perhaps a public “spectacle”. Yet the public loves it.)

In other words, looking at the political dimension alone hardly suffices for the present bullish theme…IF politics had been the SOLE DRIVER. However, in reality it isn’t. Markets comprise of multitudinal dimensions and variables, therefore, in absence of any meaningful enlightenment, our “experts” speedily arrive at flaky justifications such as the “peace dividend” bunk.

In the same manner, we can see how politicians undeservingly seize the present developments as propaganda opportunities to snare credit.

Figure 2: Stockcharts.com: World Equity Markets on A Bull run!

Where the international financial markets have shown intensifying correlation due to increasing dynamics of financial markets integration, according to Standard & Poors (emphasis mine), ``Based on monthly returns over the past five years, the S&P 500 and the MSCI-EAFE, which tracks developed markets, registered a correlation of 0.85. (A perfect correlation is 1.0.) Similarly, the MSCI-EM index, which represents emerging markets, sported a 0.78 correlation with the "500." Mid and small-cap U.S. stocks also had correlations of at least 0.77 with developed and emerging markets, as well as larger U.S. blue chips”, a 77% to 78% correlation can hardly be assessed as “insular”, it would be downright misleading to impute the domestic market’s record breaking run to “micro” activities, as shown in figure 2.

The chart shows how the world markets have been performing synchronically through the Dow Jones World Index ($DJW-Main window), iShares MSCI Emerging Markets Index (EEM-above window), JP Morgan Fleming Asia Equity (JPAIX-upper below pane) and the Fidelity Southeast Asian Fund (FSEAX-bottom pane) which all have been in a winning streak!

So while indeed several administrative reforms helped boosted the fundamental outlook for the Philippine asset class, it would be inappropriate to read through this as its main driver, since an ocean of liquidity has bolstered global asset classes of diverse nature and in different geographical zones. One must remember that foreign money flows represents a majority of our trades in the Phisix or even in other asset classes.

China’s Financial Liberalization + Global Excess Reserves =Phisix 10,000?

Figure 3: Economist: Asian Hoarders

And speaking of global liquidity, Figure 3 from the Economist depicts of the foreign exchange reserves rich countries which come mostly from Asia and other emerging markets and has signified improvements on their respective economic and financial outlook. In my view, the massive surpluses are indicative of an inflationary boom.

According to Bloomberg analyst Andy Mukherjee (emphasis mine), ``The bloated and growing Asian foreign-exchange reserves are being increasingly financed by an expansion in the monetary base. Base-money growth in China was 21 percent in 2006, double the annual average of 2004 and 2005. It was about 20 percent in Korea in 2006, six times the average in the preceding two years, according to a World Bank report last month.

``Unmistakably, Asia is contributing -- along with petrodollars and Japanese carry trades -- to a surfeit of global liquidity and a mispricing of risk....Standard & Poor's, which raised the credit rating on eight out of 34 emerging-market sovereigns and lowered its assessment on just one in the 12 months through August 2006, is talking about the need to redefine the ``emerging market'' label, and in certain cases, even eliminate it.”

Yes, these excess savings are likely to provide a floor for risk asset classes, where according to Morgan Stanley’s Stephen Jen (emphasis mine), ``This ‘real’ liquidity arises from a mismatch between world savings and investment rates. World capex has surprisingly been too low to absorb all available savings. Annually, there are some US$800 billion worth of ‘excess savings’ from oil exporters and Asian exporters to chase after assets.”

Another buoyant development likely to boost the global equity asset markets could be the recent liberalization actions undertaken by China to allow its residents to invest overseas via the qualified domestic institutional investors (QDII), which is meant to ``allow for an 'orderly outflow of funds' from the mainland and ease pressure on the yuan to appreciate, Hong Kong Monetary Authority chief executive Joseph Yam said.”

While at the onset the estimated QDII licenses covering 18 commercial banks have an aggregate quota of only around US $14 billion, where 50% or about $7 billion would be allowed to invest overseas, this should translate to a minimal impact over the interim.

However, looking at the bigger picture, this reflects a very important breakthrough as the enormous amount of Chinese savings has far reaching potential impact once totally deregulated, according to JP Morgan (emphasis mine), ``the Chinese savings pool of RMB36 trillion (more than US$4.6 trillion) has proven to be too big for the domestic stock market (market cap only RMB 15 trillion, with RMB 6 trillion floatation). EM/Asia stands to benefit the most as Chinese investors would want to have a natural hedge against renminbi appreciation, and Asian currencies are likely to appreciate over the long run along with renminbi to provide the hedge.”

So there you have US$800 million of excess “public” savings plus a potential US $2.3 trillion from Chinese resident investors that could be invested in today’s rapidly integrating world financial markets whose equity market cap according to the World Federation of Exchanges, is about $50.623 trillion end of 2006. And the noteworthy part of it is that a substantial share of these could be invested within the region (Asia’s market cap of US$11.838 trillion or 23% of the world).

Just imagine even if a fraction of the said amount would be invested in the Phisix, such would drive the Philippine benchmark to parabolic heights!

Aside from technical developments in the US markets, these efforts by China to liberalize have possibly led to the “capitulation” of one of my bear favorite analyst Richard Russell. CBS Marketwatch analyst, Mark Hulbert quotes the Dow Theorist practitioner Mr. Russell (emphasis mine), ``We saw something that is extremely rare [on April 20 and April 25], in fact I can't remember ever having seen this before. What I'm referring to is that on those two dates all three Dow Jones Averages, and -- closed at simultaneous historic highs. To me, a fellow steeped in Dow Theory for over half a century, this was like a clap of thunder... My take on the situation is that the stock market (and the Dow Theory) told us that an unprecedented world boom lies ahead."

Short Term Risks: Overheated Markets and a US dollar bounce?

Yes, despite the exuberant outlook, risks abound. Aside from the factors of excessive leverages and speculation, structural imbalances, asymmetric carry trades and untested novel financial instruments, short term risks include an overheated global equity markets following its recent sizzling hot streak. In addition, a potential rebound or rollover of the US Dollar (represented by its trade weighted index) from its recent lows could heighten volatility, as shown in figure 4.

Figure 4: BCA Research: US dollar Poised for a Rebound

Notes the widely followed independent research outfit BCA Research (emphasis mine), ``The U.S. dollar has moved into oversold territory, and according to our capitulation index a bounce is likely. Furthermore, speculators are short the currency and sentiment has been declining for the past 18 months - both measures are often good contrarian indicators. However, the bigger question for the dollar is whether there are fundamental reasons for currency strength. Currently, the global macro backdrop still supports a soft dollar. The U.S. remains the weak link in an otherwise solid global economy and further growth redistribution (via an adjustment in the currency) is likely needed. Still, any signs of improvement in the U.S. housing market as the year progresses would result in an unwinding Fed rate cut expectations and provide support for the currency. Bottom line: Betting on the dollar can be justified purely on technical grounds, but improvements in the U.S. housing picture would add momentum.”

Finally, the breakout from its 10 year range by the Phisix signifies our bullmarket is in a PRIMARY TREND, which places my Phisix 10,000 at a very attainable target.

Most of the questions I receive today allude to what issues are likely to move during this bullmarket phase of the cycle.

Over the past two weeks as the Phisix gained by over 5%, where advancing issues dominated the market with 548 against 432 decliners and 505 unchanged issues, local investors appear to be dithering as foreign money went into a shopping spree.

Because in bullmarkets it is a general rule that ALL stocks go up, previous heavyweight laggards as San Miguel and SM Investments substituted the previous heavy cap favorites in PLDT and the Ayala Group in pushing the Philippine benchmark to its recent record highs. This clearly shows that past performance does not equate to future actions, as the favorites underperformed against the former laggards.

Yet, the average investors can hardly grasp that in a bullish cycle, stocks either go into a rotation or move up simultaneously especially at cyclical peaks. The public believes that micro forces drive the local market when evidences tell us that the present cyclical advance is hardly a “micro” thing.

I’d like to repeat a very important message (which I have practiced) from Jesse Livermore, in his investing classic, Reminiscences of a Stock Operator (emphasis mine), ``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Believe me, it is a basic rule which works.

Hit by a Black Swan, My Computer Crashed!

For all this time we had been looking at the possibility of “black swan” risks or tail event risks (low probability but high impact events) that could harm our portfolios, unfortunately I got afflicted by a nasty one, but this time outside the realm of financial investing-my computer crashed!

Add to my woes is the HUGE possibly that my entire 5-year collection of financial market data, ebooks, analysts’ articles including my own have been obliterated!

Even while I was warned early this year by some friends on the exigencies of having a backup, I kept postponing the decision in anticipation that a limited access to financial sites would expose me to lesser risk of contamination.

How I was wrong.

After allowing my son to dabble on my computer Wednesday night, particularly burn some downloaded music on his CD, my windows failed to start on a corrupted window file last Thursday. After failing to successfully restart several times, I tried the systems recovery option. Then the entire system went haywire.

The lesson learned is that black swans exists even beyond the financial realm and that it pays to keep ourselves insured in whatever undertaking we do. Failure to ACT is a damning experience.

Now with shortages of references and limited access to our much required data, I am now constrained to take a “forced vacation” from my posts.

"Election Spending" Theory Validated, Phisix 3,400 Next!

The Phisix ended the week with a bang (up 2.6% week-on-week)! It closed at its highest level at 3,364.61 since the latest February "Shanghai Surprise" that stalled the upside momentum. And it comes roughly 35 points away from our 3,400 breakout target.

Yet, the peculiarity was that Friday’s rally came amidst a severe correction in the US markets (Thursday), massive corrections in commodities and a rallying USD Index. To my mind, the latest underperformance (by the Phisix) has engendered Friday’s rare 'un coupling'.

Further, the week's rally came amidst the pinnacle of the election campaign period, where the CONVENTIONAL EXPECTATION was that elections would bring about “uncertainties”. Ironically too, the remarkable rebound flies in the face of “lackluster” forecasts by mainstream analysts in support of the conventional wisdom. We asserted otherwise.

In the past, we argued that foreign money and global dynamics are far stronger drivers to our markets than political events.

We likewise theorized that today's underperformance had been most likely prompted by election spendings or of political aspirants raising funds via the financial markets during the campaign season (and NOT JITTERS), where we audaciously forecasted that at the eve of this political exercise, the stock market would recover.

Our predictions had been premised on the grounds of divergences with the relative vigor of the financial markets of our neighbors and the US markets, aside from conspicuous dissonances of the Pesos’ strength vis-à-vis the US Dollar (the traditional safehaven for local investors) and higher bond prices relative to the weak stock indices.

Friday’s close appear to have validated our view with oomph. And most importantly, likewise proved the conventional wisdom as an ILLUSION--election jitters are a myth under today's conditions.

Apparently as the ticker says we have been proven RESOUNDINGLY RIGHT; our next paradigm would be the continuing bullish momentum towards our 3,400 target and beyond. Of course, this would be achievable depending on the external environment which means a continuity of the present upbeat trend barring any significant shocks most likely sourced from overseas.

The US market’s Friday rally which recovered most of its losses would certainly be an added booster for the Phisix for the earlier part of next week. With 35 points away breaking the 3,400 looks quite imminent.

Election Spending A Drag to the Phisix?

``All great deeds and all great thoughts have ridiculous beginnings.” Albert Camus (1913-1960) French philosopher

AS the global equities melt-up continues only two countries in Asia suffered losses last week. Unfortunately so, our Phisix had been one of them down 1.2%, aside from Sri Lanka (-1.32%).

Compared to our neighbors, even Thailand’s SETI which had earlier been trammeled by the recent fiasco on capital controls had broken out of its tight range to climb 3% over the week and surge past the 700 levels, as shown in Figure 1.

Figure 1: stockcharts.com: Lagging Phisix an Election Related Issue?

The center window shows of the bedraggled Phisix (line chart and down blue arrow) against a reanimated SETI (candle and red up arrow). At the above pane is Indonesia’s index represented by the $IDDOW (DJ Indonesia Stock Index) and Malaysia’s $MYDOW (DJ Malaysia Stock Index), all of which are treading on record grounds.

Year to date, among our neighbors Malaysia’s KLSE leads in terms of nominal benchmark returns up 22.82% followed by the Indonesia JKSE (+12.62%), our Phisix (+9.92%) and Thailand’s SETI (+5.38%).

With the Phisix lagging both the US Dow Jones Industrials (as previously discussed) and our neighbors, two nagging questions come to our mind. One, what ails the Phisix? And second will the Phisix eventually join the global shindig or be caught with the corrective headwinds?

We are aware that foreign money had mainly driven the local market since 2003.

For this week, foreign money accounted for 56% of the week’s aggregate turnover. However, foreign money flows shows of a measly net Php 194.25 million worth of inflows compared to the previous week’s Php 1.2 billion. The degree of foreign money inflows have tapered off since the second week of April, ironically even as the US dollar continues to cascade, in terms of its trade weighted index and relative to the Philippine Peso.

Furthermore, this week we observe of some net foreign selling on many index heavyweights, such as Metrobank (-5.51%), Ayala Corp (-3.25%), Ayala Land (-4.11%), Globe (-1.21%) and BPI (-2.29%), as responsible for most of the decline of the Phisix. Based on the market float, the combined weightings of these 5 heavyweights constitute 32.77% of the Phisix as of Friday’s close. But, on the other hand, foreign money inflows remain buoyant over the broader market.

So here we see some mixed signals, foreign selling on select index heavyweights, but supportive of the broad based market.

In addition, we also notice that even as the Phisix has traded sideways since the second week of April, the broad market has been on a bearish bias for the fourth consecutive week, as indicated by MORE declining issues than advancing issues. We construe this as symptoms of bearishness from LOCAL investors.

In other words, over the past four weeks, foreign money remains largely defensively positive (net inflows) with occasional bouts of select selling (as last week) but the locals appear to be the major drag to the Phisix. In fact, repeatedly over the last three trading days, as the Phisix sprinted to over 20 points in gains on the record territory gains of the US Dow Jones, mid session selling dampened the trading sentiment to end the day’s session mixed. This ambivalence leads us to suspect that despite the sanguine micro environment and “bullish” global backdrop, the extent of local selling could be ELECTION related.

No, we don’t think this is about election jitters. Instead we suspect this to be about election spending. The Philippine Stock Exchange (PSE) could have been utilized as conduit, directly or indirectly (mutual funds, UITFs), for fund raising activities in the upcoming elections.

Since the PSE’s payout procedure is Transaction + 3 days, going by this line of reasoning, we expect the “election fund raising” dynamics to culminate by Tuesday as the elections are scheduled for next Monday, May 14^th.

And if our analysis is accurate, then we should see a sentiment reversal, possibly as early as the latter half of the coming week or after the elections. Of course, this would all depend on the prevailing global sentiment then.

So in answer to the two questions we earlier posed, we think that the divergences or the underperformance of the Phisix relative to its neighbors and the US Dow Jones Industrials, as possibly due to Election spending related and the probability is that as global markets remain buoyant, the likelihood is that the Phisix should regain its footing.

Stay Long the Phisix and the Peso.

Systemic Risks Rises as Leverage Mounts

``Causa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchange—whatever it may be—back into cash. In itself, causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of views which leads a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed,”-Charles Kindleberger (1910-2003) historical economist, author of Manias, Panics and Crashes.

WHILE we remain optimistic over the Philippine capital markets over the long term, several significant headwinds or systemic risks possibly posited by excessive leverage threatens the global financial markets. Since the extent of local leverage have been minimal, it would be safe to say that Philippine asset markets have not attained “bubbly” conditions. What worries us is the extent of foreign “leveraged” or chained credit exposure underpinning the Philippine asset markets.

In the past we have noted of how the world financial markets have taken up way too much leverage to shore up asset values in the search for diminishing returns. And today, we are seeing much of this “leveraging” take place in private equity buy-outs, hedge funds to even margin debt taken up by mainstream or individual investors.

In the US, according to estimates by Bridgewater Associates Inc., a Westport, Conn., hedge-fund company (emphasis mine), ``borrowing by hedge funds and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002. Hedge-fund borrowing and other financing tools were valued at $1.46 trillion last year, up from $177 billion in 2002.”

Notwithstanding, loans to companies acquired by private-equity firms jumped by about 5 times to $317.3 billion in 2006 from $51.5 billion in 2002, according to Reuters Loan Pricing Corp.

Derivatives have been used largely by hedge funds and private investment pools for institutions and wealthy individuals to go around margin restrictions by mimicking the effect of purchasing stocks and bonds at lesser upfront capital. Of course derivatives come in myriad varieties not limited to stocks or bonds but also to commodities and even to the weather.

By taking up more leverage investor’s portfolios accentuate gains when the value of the underlying assets rises. However when the invested assets fall, unlike stocks holdings where losses could translate to floating paper losses, in swaps, the hedge funds or the counterparty of a derivatives dealer (usually investment banks) would be required to pay the equivalent amount of losses in value plus the agreed upon fee to underwrite the contract.

The danger lies when losing wagers would require investors to raise significant cash and by doing so unload illiquid assets that may create pressure on today’s highly correlated asset classes.

Aside, there is also the question of the erosion in lending practices that could lead dealers to relax on collateral requirements. As in the US subprime experience, lax credit requirements has led to numerous defaults.

According to Randall Smith and Susan Pulliam, writing for the Wall Street Journal (emphasis mine), ``Wall Street itself is one of the biggest users of leverage. Last year, the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders' equity, a leverage ratio of 25.5 to 1, according to research firm Sanford C. Bernstein & Co. In 2002, those same firms financed $1.59 trillion of assets with $72.7 billion of equity, a ratio of 21.9 to 1, it said.” At 25 to 1, a 5% decline in value is more than enough to eviscerate its entire equity capital.

Mr. Warren Buffett in last week’s Berkshire Hathaway’s annual stockholders meeting again reminded the public of the dangers of derivatives, Bloomberg quotes the Sage of Omaha (emphasis mine), ``The introduction of derivatives just made any regulation of leverage a joke. It's an anachronism,'' he said. Because of them, ``there will be some very unpleasant things that happen'' in the financial markets. ``We may not know exactly where exactly the danger begins and at what point it becomes a super danger.”

Figure 2: Bank of England’s Financial Stability Report: Rising Risks

It’s not just Mr. Buffett, recently the Bank of England in its Financial Stability Report notes of rising risks due to complacency and debt expansion, as shown in Figure 2.

The BoE warns, ``The changes are relatively modest, though several are judged to have edged up. Perhaps the most notable news is an increase in the interrelated low risk premia and corporate debt vulnerabilities, with signs of a further expansion of risk-taking in global capital markets. As conduits for much of this activity, the potential impacts of LCFI distress and infrastructure disruption are also assessed to be slightly higher. The likelihood of a disorderly unwinding of persistent global imbalances is judged to have fallen slightly since the July 2006 Report, as US domestic demand growth has eased and growth in the euro area has increased.”

On the other hand, the New York Federal Reserve sounded the alarm bells on the explosive growth of hedge funds which poses as the “biggest risk of a crisis since 1998”, notes the CNN (emphasis mine), ``Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.

``Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock," the economist Adrian wrote.

As the market climbs on concentrated levered positions, this heightens volatility risks as well as systemic risks.

Since we cannot control the macro environment, and can only work with our portfolios, it would be best to position only with the amount of risks we can sleep on and to tighten our stops (given the limited investing options in the Philippine market setting).

Philippine Mining Index: Reliving The March to 9,000!

``If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.” Francis Bacon (1561-1626)

TODAY’s bullish landscape has prompted some analysts to claim that economic “decoupling” from the US as reasons behind the ebullience.

While it is true that the global economy and the global financial markets have been outperforming its US counterparts, I remain a skeptic on the “economic decoupling” driving-the-global-financial-markets premise simply because global financial assets classes have grown significant correlations with that of the US.

In my view, outperformance does not equate to decoupling, it is a low or negative correlation that signifies one. February’s “Shanghai Surprise” was a vivid example; when US markets corrected using China’s tremors as an excuse, world markets simply mimicked the developments of the US markets. Had there been low or negative correlation, global markets could simply have ignored such event or got least affected, yet that was hardly the case.

Instead, in my opinion, the “US dollar decoupling” premise seems more circumstantially evident as the declining value of the US dollar has coincided with (most possibly a causal relationship) massive capital flows towards ex-US assets.

Anyway, the recent economic slowdown in the US has been discounted by the financial markets as “the Periphery” or particularly emerging markets have taken the load of the world’s growth as shown in Figure 3.

Figure 3: BCA Research: Emerging Market’s Domestic Demand Boom

According to one of our favorite independent research outfit, BCA Research, domestic demand growth from emerging markets have alternatively functioned as an engine of global economic growth (emphasis mine),

``Similar to the U.S. during this period, emerging markets are now the main source of global growth with very vibrant and dynamic economies. Consequently, emerging market currencies are remarkably strong, which is helping drive down inflation and interest rates in the developing world to levels lower than would otherwise be the case. In turn, purchasing power for emerging market consumers and corporations is being boosted, fueling domestic demand growth and benefiting stocks levered to this part of the economy.”

This has likewise been supported by Industrial production growth outperformance by emerging markets relative to G7 as shown in Figure 4.

Figure 4: US Global Investors: Industrial Outperformances by Emerging Markets driving Commodities

According to the US Global Investors (emphasis mine), ``Emerging economies industrial production keeps its steady pace, maintaining demand for base metals, as exemplified with copper. Strong global economic growth is the critical driver behind the commodity price appreciation; historically commodity related equities follow commodity prices.”

Figure 5: Philippine Mining Index Near 1997 high!

In our October 11 to 14, 2004 edition (see Philippine Mining Index: The March to 9,000-levels), we forecasted the Philippine Mining index then trading at the 1,900 level to reach at the 9,000 levels a 1987 high (to be exact July 21 1987 high of 9,185) over the coming years.

Today the Phimine hovers above its 2006 high and closed at 6,104.66 as of Friday and is about 400 points away from its 1997 high (March 21 high of 6,502.71).

With strong global growth fueling demand for supply restrained commodities, as evidenced by recovering industrial metal and precious metal prices, aside from the benign environment conducive for emerging markets assets, we find ample support to sustain the rise in commodity related equities similar to the view of US Global Investors.

In addition, in charting vernacular, the huge bullish J.LO (coined by Wall Street with reference to Jennifer Lopez’s derriere) “rounded” bottom, represented by the green blocked arrow, as shown by Figure 5, lends us even more support on the grounds that the 9,200 barrier will be a realizable target in a not too distant future.

Stay long the mines and commodity related issues.

Many of Mainstream Media’s “Reality” Represents Skewed Consensus Thinking and a “Black Hole of Risk Reporting”

``Let’s be clear: the work of science has nothing whatever to do with consensus. Consensus is the business of politics. Science, on the contrary, requires only one investigator who happens to be right, which means that he or she has results that are verifiable by reference to the real world. In science consensus is irrelevant. What is relevant is reproducible results. The greatest scientists in history are great precisely because they broke with the consensus.”-Michael Crichton

SINCE we got engaged into this endeavor, we realize of the indispensable function of information in determining our investing decisions. Yet, faced with the availability of a multitude of information in the cyberspace, our role is to ascertain the electrical engineering equivalent concept of “signal-to-noise” ratio or to distinguish the “level of desired signal” from “the level of background noise”.

In the investing sphere NOT all information are created equal. For instance, information disseminated in mainstream media signifies public knowledge; where the likelihood is that such published information has been reflected into the prices of the underlying securities or of the markets reported. Hence, the implications of the data presented are less likely to have a significant impact on the pricing UNLESS of course, if it comes with a “dramatic surprise”.

In my case, examining the relevance of the data or theory presented and its potential ramifications, its timeliness, the manner of which it was presented or the “framing” process, the “implied” biases reflected by its author and/or the publishing entity, aside from their credibility or reputation and most importantly the latent motivation or incentive for such article.

Remember, for the conventional news outfits, it is SELLING the news which counts more than simply conveying the information. Why do you think controversies or sensationalism mainly hug the headlines (whether it is your favorite broadsheet or prime TV news station)? Is it not there to catch your attention?

And since the business of mainstream media is to sell news, then it is quite obvious that the current or du jour “sentiments” underpin most of their articles. What you may believe as “reality” are most likely present fashions or trends and may yet be susceptible to change, whether it is comes from the Fox, CNBC, CNN, the USA Today or the New York Times, Manila Bulletin or Philippine Daily Inquirer.

Take for example, market Guru Jim Rogers’ experience. When interviewed in mainstream media in the late 1990s where he predicted the revival of the commodities and the China investing themes, his ideas were simply shrugged off and dismissed as “...anchors were still giggling with glee still advising to buy more dot-com shares.” Now, of course, everyone knows what happened next.

My own experience post 9/11 “day of infamy”, was when the PRO-war sentiment has dominated the airspace, your analyst, by taking the usual contrarian stand, joined the war debate by taking his conviction, a letter of rejoinder to a pro-war columnist in Businessworld. The financial genius columnist quoted me verbatim, albeit anonymously, in his column and promptly rebutted my arguments. I was no match against his eloquence though. But 6 years from the war, it is a wonder how media’s “reality” or sentiment has radically changed.

Another example was from last week, where we pointed to the inconsistencies of the article underscored by a “bias” quoted from an expert who was incidentally an authority from a top government bank. While the articles’ prominence, given by its frontpage treatment, could likely be indicative of the snowballing trend towards national awareness of the Philippine capital markets, the banker’s “risk-free” suggestion of their products lack the perspective of the risks provided for by eroding purchasing power via inflation. So aside from popular sentiment, you have “biased” opinions pervading mainstream media.

In short, news from mainstream media represents MOSTLY consensus thinking. And consensus opinions have proven to be glaringly wrong especially during major inflection points of any trend be it scientific, social, political or financial trends.

Let me quote Elliott Wave’s Alan Hall who enumerates past scientific “reality” by the consensus:

``Some ideas accepted by popular consensus that are now rejected:

-The flat earth

-Geocentrism

-The harmlessness of tobacco

-The link between electromagnetic fields and cancer

-The benefits and harmlessness of leaded gasoline additives, followed closely by

-The benefits and harmlessness of MTBE gasoline additives

-Nuclear Winter

-Y2K”

And that’s the reason why contrarian analysts utilize so-called “Magazine cover indicators” to discover misguided but deeply entrenched popular beliefs and promptly bet against them.

Finally, mainstream media could also suspiciously serve as conduits for politically veiled agendas. For example, as in the war in Iraq, mainstream media seems ever so obsessed with the potential menace of H5N1 (whose pandemic reach is something we DO NOT DISCOUNT).

However based on present facts (of course such dynamics could change), the death toll from malaria, according to the World Bank, is about a million a year or 3,000 children a day far exceeds that of the much feared H5N1 virus.

While we certainly are NOT qualified to offer expert opinion on such matters, we quoted this previously from risk communications expert Peter Sandman (which continues to haunt us), ``The basic reality is the risks that scare people and the risks that kill people are very different...When hazard is high and outrage is low, people underreact, and when hazard is low and outrage is high, they overreact”.

Lately Mr. Sandman provides for more explicit examples of such media covered hazard-outrage asymmetries (emphasis mine), ``As for high-hazard, low-outrage risks — smoking, driving without a seatbelt, obesity, and the like — media coverage tends to be scanty and dutiful. These are the stories that are simultaneously too serious to sensationalize and too boring to cover straight. They’re the black hole of risk reporting.

``There are certainly times when the media sensationalize serious risks, especially in “docudramas.” But in news, sensationalism is most common in stories with no serious implications for public health. “Flesh-eating disease” gets sensationalized; terrorism usually doesn’t.”

This leads us anew to question on the present dynamics...

While it is true that Malaria appears to be confined to low income countries while the H5N1 virus has pandemic potentials, could it be that the world has instead been overreacting to a “fear-imposed outrage”? Or could it be that such “sensationalized outrage” have been utilized as justification for more government “carte blanche” intervention?

And you can look elsewhere for the application of such mainstream media promoted popular consensus themes...

As German Philosopher Oswald Spengler once wrote (emphasis mine), ``The press today is an army with carefully organized weapons, the journalists its officers, the readers its soldiers. But, as in every army, the soldier obeys blindly, and the war aims and operating plans change without his knowledge. The reader neither knows nor is supposed to know the purposes for which he is used and the role he is to play. There is no more appalling caricature of freedom of thought. Formerly no one was allowed to think freely; now it is permitted, but no one is capable of it anymore. Now people want to think only what they are supposed to want to think, and this they consider freedom.”

That’s why I don’t ask you to just trust me, read diverse “non-mainstream” opinions for your intellectual freedom.

Prudent Investor Suggests: Overweight the Phisix More than the Dow Jones Industrials!

``Much has been written about panics and manias, much more than with the most outstretched intellect we are able to follow or conceive; but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money.”-Walter Bagehot, English Journalist (1826-1877)

The markets appear to be headed in the direction which we have been anticipating albeit in a much gradual fashion. Yes, contrarians need the crowd to bolster their prescient views or investment positions.

Following the dynamics of the US markets, the Phisix breached its minor resistance levels to a high of 3,350 but closed back to within its new support levels/previous resistance. The Philippine benchmark ended the week up 1.95%, as the Peso continued to set new milestone 6 year highs at Php 47.46 against the US dollar.

While we are aware that the market action risk increases in an environment where momentum gets overheated, any present market declines in spite of the traditional seasonal weakness could possibly mean a pause rather than a reversal.

Taking a cue from Mr. David Kotok of Cumberland Advisors, ``We would now say to “sell in May” if the Fed Funds futures market was demonstrating an expectation that the Fed was going to hike in the future. This is currently not the case.” In other words, while Mr. Kotok expects the low interest rate environment as conducive for equity markets investing, we keep my fingers crossed.

The US dollar (trade weighted index) fell to near record levels as the Euro surpassed its December 2004 high ($1.3667) to set a fresh record at $1.3682. The euro closed at $1.3634 up .26% for the week.

As previously shown, we think that the falling US dollar has been the ONE major pillar which has lead to money flowing out of the “orthodox” US markets to the non-mainstream markets as the emerging markets or even timber (from Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo).

A friend asked me recently on a choice whether to maintain his portfolio of US investments in the US equity markets or the Phisix. My obvious response was that it would be best to keep ourselves diversified. However, Figure 1 shows how the Phisix performed over the past three years as deflated by the US DOW JONES INDUSTRIAL Index.

Figure 1: stockcharts.com: The PHISIX vs. THE Dow Jones Industrials

The upper pane accounts for the movement of the US dollar trade weighted Index, while the lower pane represents the Morgan Stanley Capital Emerging Free Index. The center window shows how the Phisix performs relative to the Dow Jones Industrial Averages such that if the Phisix is outperforming the Dow Jones Industrial then the chart shows of a rising trend, and vise-versa.

The purpose of the US dollar is to once again show its PAST and PRESENT correlation with that of the Phisix, emerging market index and of the Phisix-Dow Jones activities.

Again, it is quite evident that over a longer period, particularly in 3 years (as the maximum coverage for FREE use), the Phisix has largely outperformed the US Dow Jones Industrials in an environment where the US dollar has been falling and vice versa.

Presently in spite of the weakening US dollar, the Phisix has consolidated and has not been at par with its previous performances, hence the red diagonal triangle at the rightmost edge.

Our question is: has the present underperformance been an outcome of “overvaluation” or an “exhaustion” from the previous run? Or will the Phisix eventually come up with a similar “lagged” rendition as shown in many instances in the past?

So before coming up with our answer let us look at the broader picture.

Heavyweight contrarian Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo, thinks that world assets are in a bubble, where he says (emphasis mine)

``Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.

``Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you. And of course, as often mentioned, this is helped along by the finance industry, broadly defined, that makes more money when optimism and activity are high. Hence they have every incentive to support rising markets as they do.”

While we agree with Mr. Grantham that some parts of the world have shown lathered or frothy conditions we do not subscribe to the idea that every asset class is a bubble yet.

Of course we could be speaking from a “conflict of interest-finance industry” point of view.

Relative to the Phisix, the degree of bubble exposure depends on how much credit money has been linked to the Global credit chain, which has buoyed the present state of the market.

In the same circumstances, we can hardly construe Japan’s equity market as being lifted by strong “animal spirits” to the same degree as in the US or some OECD countries. Japan has been experiencing a NET outflow due to residents looking for higher yields abroad.

Like us, Mr. Grantham raises the question of an imploding bubble as a question of timing. Mr. Grantham wrote, ``Of course the tricky bit, as always, is timing. Most bubbles, like internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time but dramatic in extent. My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right.”

Yet in the face of these bubble fears, we are seeing a radical trend shift of money flows towards non US markets, Alan Murray recently wrote in The Wall Street Journal (emphasize mine), ``We are witnessing a crucial moment in history -- the movement of U.S. capital markets abroad."

Tim Hansen of the Fool.com adds, ``Nine of the 10 largest IPOs of 2006 and 24 of the 25 largest IPOs of 2005 occurred in foreign markets.”

Deflationary “bust” advocates predict that a bubble implosion would result to a panic driven safehaven rush towards the US dollar and US treasuries, the premise being that the US as the most liquid and sophisticated market. Yet present day evidences have proven otherwise, as shown in Figure 2.

Figure 2: World Federation of Exchanges: World Equity Markets Overtake the US

Since global markets have bottomed out in 2002, the share of US markets relative to world markets in the context of market capitalization has shrunk from 52% to 45% in 2006. This is because Asia has generated the best returns up 168% over the same period compared to Europe’s and MENA (Middle East and North Africa’s) 140% and the Americas at 90%.

And as we have previously pointed out, this dollar “decoupling trend” has not been limited to the equities market but also to bond markets where the Euro has displaced the US dollar for the second year in succession, or to Euro notes in circulation exceeding that of the US dollar or to the falling share of the US dollar as foreign exchange reserves, but retaining the majority, in the global banking system.

In addition, with the emergence of “Sovereign Wealth Funds” [SWF] or countries with foreign exchange reserves surpluses which assigns a separate national entity or public “fund” to manage or invest excess reserves, the likelihood is that these trends will be further accentuated.

Remember, in the recent past, excess reverses by Asian countries or Oil Exporting states have been recycled into US assets. Today, the thrust to diversify from the US dollar assets appears to be taking place via the medium of SWF into the global financial markets.

How much funds are we talking about? An estimate by Morgan Stanley’s Stephen Jen is that 24 of these funds hold some $2.3 trillion or about 5% of 2006 market cap with growth of about $500 billion a year! Now with public financial “funds” beginning to compete with private funds for returns, yields are going to be more marginalized than ever although risky assets could be more supported as liquidity flourishes.

However, could the financial instability side today emanate instead from the fundamentally altered world financial risk profile as Mr. Stephen Jen recently suggests? Perhaps. Apparently we are witnessing the emergence of new financial paradigms or evolutions in the financial system at work, although like the innovative financial products, these have not been stress tested and could be sources for volatility (such as politically induced ones). And that new paradigms or “different this time” axioms give us jitters.

Present developments tell us that in spite of the present lethargic economic state (real GDP of the US grew below market expectations of 1.3% on high GDP price index) US financial markets appear to be experiencing a prolonged bonanza (DJIA up 1.23% for the fourth consecutive week). However, as exhibited above the gist of the benefits has been moving away from US assets and into global markets.

Could such developments underscore the unintended consequences from the highly taxing Sarbanes-Oxley Act? Or could the US dollar’s woes have prompted for the exacerbation of such trend of outflows? I think more of the latter is the culprit.

For me, Mr. Doug Noland of the Credit Bubble Bulletin, has got the best answer among the analysts I monitor (emphasis mine), ``U.S. securities markets continue to lag much of the rest of the world. Yet there is an ingrained market perception that financial tumult/crisis is invariably instigated at The Periphery. Participants have been conditioned to believe that risks and excesses are greatest with the inherently fragile “emerging” markets. These markets have also tended in the past to perform as credible “canaries in the mineshaft,” warning of more generalized financial turbulence. So with emerging markets again trading well and crude and commodities on the rise, complacency with respect to the general liquidity backdrop has returned with a vengeance.

``Here’s where the markets could have it gravely wrong: the greatest vulnerabilities associated with the most egregious (ongoing) excesses today reside not at The Periphery but at The Core. Indeed, current global liquidity excesses are now exacerbated by heightened excesses and flows away from The Core, in the process masking heightened securities market fragility throughout The Core.”

Put differently, if the credit excesses have been due to the US (The Core) why would a bubble implosion or a panic driven run lead money back (from where it originated) and not towards the Periphery (global markets)? Could today’s developments instead serve as an initial manifestation of a deepening trend in preparation for such “tailed event”?

Further if capital outflows would translate to higher interest rates in the US, does it suggest that higher rates could stanch such exodus?

Mr. Axel Merk of Merk Investments debunks such myths (emphasis mine), ``It seems that ever since academics developed a theory of how interest rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus in on interest rates. Why do some low yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?

``A good year ago, the U.S. joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher U.S. interest rates mean higher payments abroad, further weakening the foundations of the U.S. dollar.”

So aside from speaking from the perspective of a “home biased” investor, our analysis leads us to think that risks for more declines in the US dollar could exacerbate outflows from US capital markets into the world. This perhaps validates why our 90 day treasuries have been lower than that of the US counterparts.

Given the above premise, I guess the “appropriate” suggestion for my friend would be to give weight more into Asian assets or to the Phisix than that of its US contemporaries.

Could Brent’s Premium Over WTI Imply a $70 above Oil prices?

``Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” Lao Tzu, Chinese Philosopher

At the start of the year despite being apprehensive over the prospective performances of global equities markets we remain buoyant on oil prices on two basic premises; one, Peak oil, where about 80% of global oil reserves are held by national oil companies, non-transparency, market distortion from government intervention and politically instability from resource rich countries has continued to placed a restrain on the supply side from adjusting to market requirements.

For instance, would you believe that despite being an oil exporting country starting May 21^st Iran will be rationing its gasoline? Yes, the country is said to hold 10% of the world’s oil reserves but subsidies have kept its supply consumption high. Reportedly high consumption levels could have been corollary to the government imposed subsidies as some have undertaken to smuggle oil and sell it at global prices beyond its borders.

When we say peak oil we mean the end of “cheap oil”. While technology has enabled access to once prohibitively costly oil patches [e.g. deep sea], national policy restrictions have been a huge barrier in expanding supply access even with such added technology at hand.

Take for instance Mexico’s once prolific Cantarell oil field, one of the largest in the world. Last year its production dropped by a significant 20% from 2 million barrels per day to 1.6 million barrels a day. Some estimates have even placed the field to produce by less than 500,000 per day or an equivalent 75% drop in 2010, according to Petroleumworld.

Yet Mexico’s national oil company Pemex suffers from foreign investment restrictions embedded in its constitution from which its two past chief executives have failed to persuade members of the Congress to have this lifted. As a result Mexico, according to Wall Street Journal, may become an oil importer within eight years!

Of course the other factor major factor is the declining US dollar.

Lately, I stumbled across a very compelling argument posed by analyst Elliott Gue of the Energy Letters where he notes of the present disconnect between the benchmark crudes of the WTI (West Texas Intermediate) and Brent Crude which could translate to a significant impact on oil prices.

Figure 3: Energy Letters: WTI-Brent spread breaks!

The WTI crude is of higher grade sweet crude and is widely used in the US and benchmarked by US refiners while the Brent Crude is of a lesser grade sweet crude than the WTI but is commonly used in Europe and in Asia and likewise benchmarked by the refiners of the respective regions.

Figure 3 shows that in the past seven years WTI maintained an average premium of $1.72 relative to the Brent. However recently, the Brent Crude turned negative by a huge amount. Such negative spread reflects of the global demand supply imbalances which could possibly induce higher crude oil prices in the coming months.

Mr. Gue says ``When Brent trades at a significant premium to WTI, US refiners start refining more WTI (and other types of crude) and less Brent. This reduces demand for Brent and pushes up demand for WTI, putting downward pressure on Brent prices relative to WTI.”

Figure 4: Stockcharts.com: US Gasoline prices reach Major Resistance Levels!

As we enter the major driving summer season in the US, a sharp drop in gasoline inventories has caused a spike in gas prices. Where the U.S. transportation sector accounts for 66% of all U.S. consumption, the recent spike in Gas prices hardly signifies a slowdown with its economy.

Figure 4 shows that in the past 3 years, each time gas prices reach the resistance levels, oil prices hit the $70 or more per bbl area, however today we see a virtual lag in the WTI prices. Technicians may see today’s actions as a sell based on previous price behavior over the past three years, but I wouldn’t bet on it.

While gasoline inventories have been dropping, crude inventories have stayed high due to low refinery utilization or bottlenecks in the supply chain as refiners reduced outputs due to maintenance related outages. However the refiners are expected to pick up the slack by completing their maintenance work soon, and should be expected to use up quickly the higher than average inventories.

On the other hand, global inventories of crude oil have dropped sharply, crude oil inventories fell to about 80.5 million barrels last February. Further, the IEA estimates that the combined supply in the US, Europe and Japan have declined at a rate of more than 1 million barrels per day during the first quarter of the year; a higher than average decline for the season.

In short, the negative spread reflects the quickening depletion of crude stocks abroad relative to the US, hence the negative spread. And this should imply for higher prices in the interim as US seasonal demand picks up and where supply imports by the US are expected to rev up in order to augment current stock levels.

Quoting Mr. Gue, ``But with US oil benchmark (WTI) prices below prevailing international benchmark (Brent) levels, US refiners are going to have trouble finding any oil to import; better oil prices are available internationally than in the US. Of course, there are certain oil supplies (such as Venezuelan heavy crude) that are relatively captive to the US market. However, with WTI prices so far under international levels, it will be tough for the US to attract additional barrels.

``It's simple economics: If the US is going to attract imports, US benchmark prices will need to rise toward international levels and WTI will have to close its discount to Brent.”

``Moreover, as US crude inventories start to draw lower and the nation begins importing again in earnest, this will represent another wall of demand for the international crude oil markets. In other words, strong US gasoline demand will eventually represent a strong draw on global crude oil supplies. Those supplies are already tight, and OPEC shows no sign of letting up on its campaign to cut output.

So fill up your gas tanks as oil prices are due back to the $70 levels and above. On the hand, you may consider oil stocks as insurance.