In A Bear Market, Doun’t Count on Lady Luck

``Lucky fools do not bear the slightest suspicion that they maybe lucky fools-by definition, they do not know that they belong to such a category. They will act as if they deserved the money. Their string of successes will inject them with so much serotonin (or similar substance) that they will fool themselves about their ability to outperform the markets (our hormonal system does not know whether the successes depend on randomness)”- Nassim Nicolas Taleb, Fooled by Randomness

As a saying goes, ``When it walks like a duck, quacks like a duck, it must be a duck!” And so it was.

Everything came so swift and furious that practically swept the floor from the bewildered public. The intensity of the carnage even landed in the FRONT PAGE of national broadsheets!

While it came to a surprise for most, it was not as much for us (except for the degree of decline) since we have seen such risks snowball. We began to play the role of AESOP’s “THE BOY WHO CRIED WOLF!” as early as the last week of July (see July 30 to August 3 edition, “US Mortgage Crisis Contagion: There is NEVER One Cockroach!” and “Technical View on the Phisix: The Path of Least Resistance is Down”), although needed more confirmations until last week, when central banks collectively moved which served as the clincher for us to essentially declare a contrarian cyclical BEAR MARKET call.

Well, based on the news account, these are some of the comments on the latest bloodbath from our industry’s bigwigs, “as if they don’t have value at all…”, “thrown fundamentals out the window”, “they’re getting cold feet”, “difficult to differentiate between a bear market and a deep correction…you should be buying right now because there are values out there. Stocks have come down 20-30 percent from the peak” and “it was a case of “emotion taking over””.

In fairness to these “highly-paid-to-be-bullish” personalities, they might have been quoted out of context. To our experience, media quotes from analysts are usually based on what the media or the reporter DESIRES to present (framing) and NOT exactly the message conveyed by these analysts. We had been an unwitting victim of such circumstance and stands as the reason why we refuse to be a part of these journalistic circuses.

However, in the face of such “frame”, obviously such comments reflect a BIG sense of DENIAL. Now considering their stature, academic backgrounds, network privileges and importantly liberal access to information, research materials and resources, they should KNOW better.

Yet we understand why they “tunnel” or ``neglect of sources of uncertainty outside the plan itself” (NNTaleb-Black Swan) simply because they operate under the economic and financial incentives that buttress the entities which sustains them. Succinctly, our industry makes money when we are bullish.

Self-development author Robert Ringer in his article “Beware of False Perceptions” hits the nail on the head (highlight mine), ``Action is the starting point of all progress, but an accurate perception of reality is the foundation upon which a successful person bases his actions. A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

Or we might say their lack of awareness of ignorance, to quote J. Kruger and D. Dunning in “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Self Inflated Self-Assessments” (highlight mine) ``In short, the same knowledge that underlies the ability to produce correct judgment is also the knowledge that underlies the ability to recognize correct judgment. To lack the former is to be deficient in the latter.”

Let us now delve with the facts; on the account of the global shakedown, the PHISIX was down 12.12% for the LARGEST weekly decline we’ve seen during this cycle. It has been FIVE consecutive weeks since the Philippine benchmark has started to unravel and has lost about 25% from its recent high of 3,820. Year to date from a huge positive return has now turned NEGATIVE down 3.29% as of Friday’s close.

In addition, if the week that ended in Aug 2 was one remarkably huge negative market breadth at 4 decliners for every one advancers; this week’s activities was even more amplified at 5.8 to 1 (29 advancers to 551 decliners)!

In essence, the polemics of whether we are in a correction or BEAR market is all about semantics or definition in the eyes of the observer. In the US, a normal correction is perceived to be at the 10% level, where something beyond it is accounted as the “gray area”, while 20% or more becomes a bear market. So, if we go by their definition then evidently we are in a BEAR Market. Of course, we expect the bulls to argue otherwise.

Yet as last week’s discourse, bear market cycles are typical occurrences within a secular trend. The Phisix can lose 50% to 60% as in the past cycle (1987 and 1989) yet proceed with its secular bullmarket trend. These are the defining features of ANY market cycles. (Caveat: I am not implying that Phisix will fall 50-60%, I am saying that we should NOT dismiss the risk of such outcome, especially under present hostile conditions.)

Nonetheless, to aver that market trades “without fundamentals” or trades in “an emotional state” during a panic selloff represents an entirely biased view. It presumes that investors have gone irrational, ONLY when it comes to a DOWNSIDE.

When the market moved up, or even panicked up, does it mean that our investors rationally priced securities under the conditions of “fundamentals” sans speculation?

How is it that we have “cult stocks” flying over based on fantastic stories but with negative assets or cash flows? Yet the public with the help of media bought into this grand tomfoolery. Now, Newton’s Third Law of Motion comes into play, where ``For every action there is an equal and opposite reaction.” In short, we simply get what we deserve.

As we have always argued, the human mind sets prices in the markets, where values are determined subjectively in combination to one’s perceptions of utility or usefulness, scarcity and time preferences. Thus, the market simply responds to the stimulus that directs such expectations.

Again it pays to HEED the all important lesson by Edwin Lefèvre, a.k.a. Jesse Livermore, in the book Reminiscences of A Stock Operator (highlight 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 all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a 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 doesn’t even wish to think.”

Especially with emphasis to our juvenile market, going against the tide is a recipe for portfolio catastrophe.

In our field, what intrinsically matters is the OVERALL APPROACH to one’s portfolio under the prevailing conditions. For instance, at the present turn of events, does one hold on to losses and endure the agony of diminishing price values-to simply HOPE and wait out until the cycle reverts to its secular trend, or does one learn to absorb losses to preserve capital for future undertaking? I have explained to you last week the mathematics of Cutting losses.

A choice is always about a tradeoff on something or some events, known as opportunity cost or economic cost. At present, it looks more likely a choice between capital preservation and the opportunity to lose more than to gain (again I hope I would be wrong).

Getting emotionally attached to the markets can be highly stressful, where conflicting expectations of “not wanting to be left out” and “facing losses” have been today encompassed by the “inability to accept mistakes”. No amount of information will supplant the inherent biases by speculators who will seek everything to justify their losing position regardless of the market’s action. That’s why BEAR MARKETs are described as “descending on a ladder of HOPE”, because hope and illusion and NOT rationality and the acceptance of reality becomes the order of thought.

It is also why HUBRIS or overconfidence exacts a heavy toll on the speculative public who come to believe that their streak of wins becomes an everlasting trait or that the markets function to oblige them without prudential risk assessment.

When it is all left to Lady Luck, in a bear market, then she may have as well turned on them.

Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?

``The object lesson is that whatever convincing arguments politicians may advance to justify yet another piece of draconian legislation, you can be certain that the authorities will misuse and abuse it for totally different and repressive purposes.”-Martin Spring, analyst

Well if you think the equity markets are simply undergoing a normal corrective phase then think again.

Figure 1, tell us that in spite the previous collective central bank actions to mitigate the emergent strains of financial stress, we are seeing these developments spread to almost the entire spectrum of the financial market universe.

Figure 1: The Problem Looks like System-wide Deleveraging

This has not been solely confined to the subprime space as we also now see a massive unwinding in the Carry Trade phenomenon, where as the Japanese Yen breaks out massively from its resistance level (horizontal line) seen in the main window, as the Australian Dollar, seen in the upper pane, a key beneficiary of the carry trade, collapses. The Australian Central Bank had to even intervene to shore up its currency last week!

Coincidentally as the Japanese Yen spiked way beyond its key resistance level, we also note that the JP Emerging Markets Debt fund (upper window below center) or an index of sovereign bonds from emerging markets have simultaneously accelerated its declines, alongside the Dow Jones World Index (lowest panel). The vertical line underscores the timeline of seemingly synchronous activities.

So what appears to be a synchronized deterioration in market action from corporate bonds to sovereign bonds, to money market instruments to derivative markets to the currency markets seems symptomatic of a financial system wide phenomenon called “DELEVERAGING”.

Christopher Wood, a respected strategist at Credit Lyonnais Securities Asia who recently scoffed at the interventionist activities of global central banks made a piquant remark which I quote (highlight mine), ``The grim analogy that most resembles securitisation run amok is a body ravaged by a spreading cancer”.

The clear and present danger is the vulnerability of today’s Fiat Based Currency system to inflationary abuse, fraud and to excessive leveraging and speculation, which American Economist and the Father of Financial Instability, Hyman Minsky described as the Ponzi Finance model, (we touched on this, see March 5 to March, US Markets: Risks of Ponzi and Speculative Finance).

Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).

Minsky’s model likewise accompanies the loosening of credit standards by lenders, intermediaries and regulators as a consequence of a boom, aside from financial engineering that allows for more credit creation and intermediation.

Mr. Martin Wolf of the Financial Times has a fitting boom-bust cycle interpretation of the Minsky model (highlight mine),

``The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

``The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

Essentially the culmination of the Minsky Model is the ensuing COLLAPSE of the Ponzi finance system, prompted by the drying up of credit even to creditworthy borrowers and a Panic. George Magnus of UBS once coined this as the “Minsky Moment”. In other words, the house of cards built upon by too much credit fundamentally falls under its own weight and the repercussions constitute a massive selloff to pay down obligations which results to a system wide panic. Some of signs these we are indeed seeing today.

The important question facing us investors is that “are we facing the crossroads of the Minsky Moment”? Will the present actions by global central banks be sufficient enough to mitigate the unraveling of current highly leveraged conditions?

Another of our favorite independent analyst, the once bullish BCA Research has manifested a whiff of alarm in their latest outlook as shown in Figure 2.

Figure 2: BCA: FED Rate Cuts Imminent?

This from BCA Research (emphasis mine), ``Illiquidity has spread beyond subprime-related markets. Banks are wary about lending each other money. Speculative-grade corporate bond issuance has ground to a halt and the asset-backed commercial paper market has seized up, even for high-quality investors. It is when even high quality borrowers lose access to capital markets that alarm bells ring for central bankers. Our financial stress indexes are higher than they were in 1998. True, policymakers do not wish to be seen as bailing out poor investments. Nonetheless, in the end they have no choice if credit markets begin to freeze. Bottom line: unless market liquidity improves in the coming days, the Fed probably will provide an inter-meeting rate cut. The Bank of Canada will likely follow suit, given similar financial strains. The ECB will likely wait to see if Fed action calms the markets.”

So interim reactions by the global financial market will essentially determine the chain of responses from global monetary authorities, if today’s purported measures of elixir don’t work.

To further illuminate on the anatomy of a crisis, we’d like to quote Charles P. Kindleberger on his 1976 book Manias, Panics and Crashes anent the “ONSET of a CRISIS” p.92 (highlight mine),

``Causa Remota of the crisis is speculation and extended credit; causa proxima is some incident that 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 that leads to a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed. To the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls on them for margin or cash and to further liquidation. As prices fall further, bank loans sour, and one or more mercantile houses, banks discount houses, or brokerages fail. The credit system itself is shaky, and the race for liquidity is on.”

Doctors diagnose the ailments of their patients based on exhibited symptoms. The patterns seen in the Kindleberger Crisis paradigm and the Minsky Model uncannily parallel a brewing crisis at hand. Could it be a full blown financial crisis? We don’t know and we hope not. Yet we are uncertain if this juncture will simply just breeze over.

Some institutions think that we are at the levels of maximum “uncertainty” and advocate the Rothschild maxim of “buying when there’s blood on the street”. We doubt so.

In determining whether it would be the propitious time to invest, there is supposedly the distinction between risk and uncertainty from which we may consider when evaluating. To borrow from economist Frank Knight’s (Risk, Uncertainty and Profits) definition, which we will quote economist Nouriel Roubini in his blog (highlight mine), ``In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”…Risk can be measured and priced because it depends on known distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to “fat tail” distributions and extreme events that cannot be easily predicted or measured.”

Learning from the recent events, the initial stand by the mainstream market participants was TO DISMISS the contagion risks from the US mortgage crisis citing its limited share to the overall markets and as share to the GDP. Suddenly, the credit spigot seemed to have been turned off, where from one markets to another, global financial markets essentially felt the tremors escalate, sold off steeply and then central banks stepped in with liquidity injections and NOW the FED’s discount rate cuts.

In other words, what was initially viewed as a “contained” problem turned out FAR from mainstream expectations. Markets reacted way beyond what participants expected. Many got hurt and this has YET TO SHOW. Consequently, the financial industry beseeched to be bailed out and appears to have gotten what they wished for. Question is, has the present bailout been adequate?

Given the huge underestimation by Wall Street, and given the embryonic symptoms of a financial crisis, these represent the prospects of an “incalculable outcome” or “uncertainty” in the Knightian terminology. Remember, financial crisis have far reaching effects. Take the impact to the Phisix in 1997 as shown in Figure 3.

Figure 3: Asian Financial Crisis: Phisix lost 70%

The Phisix in 1997 to 1998 REACTED VIOLENTLY to the Asian Financial Crisis. In over one year and a half, the Phisix fell by nearly 70% from 3,400 to 1,076. As you can see the overall trend was DOWN but had a couple of bull traps in between the general trend. This is where “knife catchers or bottom pickers” thought they had “timed” the market’s bottom when they actually were false dawns. One can just feel the pain of miscalculation.

We don’t know if another crisis would occur. We sincerely hope it does not. The point is, when we are faced with a LIMITED upside relative to the risk prospects with an immeasurable downside or earning opportunities is limited relative to greater opportunities for losses, we simply don’t take the trade.

While we can’t control what happens to the financial markets or economies, we have CONTROL over our portfolios.

We don’t mind buying higher for as long as the “uncertainty” prospects abate. So far this hasn’t been the case.

US FEDERAL RESERVE Is Financial Markets Sensitive!

``By definition, the center is the provider of capital , the periphery the recipient. An abrupt change in the willingness of the center to provide capital to the periphery can cause great disruption in the recipient countries. The nature of the disruption depends on the form in which capital was provided. If it was in the form of debt instruments or bank credits , it can cause bankruptcies and a banking crisis..."-George Soros

When the seminal bouts of financial stress began unveiling late July, we took the stand that monetary authorities were likely TO INTERVENE with corresponding policy measures (see July 23 to 27 edition Under the Threat of Recession, The FED Will Likely Cut Rates!).

Some monetary figures and experts overconfidently claimed that the FED will NOT intervene because the housing recession had been assumed to have little effect on the economy and the financial markets.

On the other hand, we suggested that the performances of the financial markets are likely to be the key barometers monitored by the US monetary authorities, despite their vehement denials (they are purportedly not to influence asset markets). And to us, it seemed that this sector mattered more than economic figures, since…

1.) Financial assets comprise the CORE source of funding to the consumption patterns for the US households which make up about 75% of the US GDP.

2.) The global financial markets have DWARFED the global real economy (exchanges of goods, widgets and services) and lastly…

3.) The activities in the US markets have been TRACKED CLOSELY by global markets, which similarly could influence the general global economic momentum.

Under such construct, our projections were weighted on the performances of the US financial markets, in contrast to most experts. Here we asserted that a significant decline in the US markets will compel the FED to trigger its Rescue Package, (see July 30 to August 3 edition, A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Put).

Recently in view of the upheavals in the market largely influenced by the spreading of credit drought, global central banks INITIATED such operations by injecting more than $300 billion of money “created from thin air’ to the increasingly distressed financial sector, where the US FEDERAL RESERVE even accepted mortgage backed securities as collateral in exchange for loans.

We even suggested last week that the FED will use its remaining tools under duress which proved to be prescient…``The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon.”

Thursday August 16^th appears to have been the crux of the FED’s decision to trigger the NEXT DOSE of the Bernanke Put…

Figure 4: New York Times: A Day of Wild Market Swings and Global Anxiety

According to the New York Times article by Jeremy W. Peters and Louis Uchitelle (emphasis mine), ``At one point during the trading session, major stock indexes were down more than 10 percent from their peak last month — the threshold for the market’s fall to be considered a “correction.” But by the close, the overall market had escaped that territory, powered by a rush of buy orders in the last hour, leaving Wall Street not far from where it ended the day on Wednesday.”

So essentially what happened was the Dow Jones Industrial benchmark crossed over our projected frontier. The intraday trend of the Dow Jones Industrial in Figure 4 from the New York Times, shows of how the main index TRANSGRESSED the 10% threshold…down a little over 340 points during the mid-session!

But in the final hour, the key benchmark got a reprieve from a barrage of late hour buying orders (from the PPT/President’s Working Group perhaps?) to close down by only 15 points! With central banks apparently pumping up the financial system, it isn’t a remote probability to have the US government propping up such key indices.

Nevertheless, the mixed close on Wall Street did not DETER Japan’s market to a swan dive last Friday down by as much as 5.42% at the close, as shown in Figure 5!

Figure 5: stockchart.com: Nikkei’s Swan Dive

Other key Asian markets fell but was able to reverse much of their losses likewise during the final hour. Hong Kong’s Hang Seng Index seen in the topmost pane, the Dow Singapore benchmark (upper pane below center window) and our own PSE following Japan’s collapse in a free fall.

In the meantime, European markets were trading in the red likewise early last Friday, while US futures were initially in deep losses. Then the unexpected happened, FED announced its discount rates cuts before the opening and saw its markets flew as the bells rang!

Again, the Fed’s timing of the discount rate cuts (before the opening) as well as last hour activities in the US markets on Thursday COMPOUNDS OUR SUSPICION of government’s stealth but revealing efforts to levitate the financial markets.

Nonetheless, in support of the recent monetary actions, we note of a volte-face on its priorities.

Early last August 7^th the FOMC declared that the predominant risk had been inflation, although they noted that the risk to the economy has grown (highlight mine)…``Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.”

On Friday August 17^th the FOMC stated that deteriorating market conditions has shifted their risk concerns from inflation to economic growth (highlight mine)…``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I recall William Poole President of St. Louis Fed, who recently declared that it would take only a “financial calamity” to impel the FED to act. The following day, the FED admits of a shift in gears in support of the markets. This implies burgeoning risks for BOTH the US economy and the financial markets.

In the light of such admission, how does one become bullish when the monetary authorities themselves are apparently reacting to the escalating risks through the recent anodyne treatments in the hope that such would restore the balance?

In the first place, wasn’t it their encouragement through their expansionary policies to enter into inflationary excesses which has caused this problem? It’s like feeding more drugs to addicts.

Yes, some features of the latest policy actions could buy some time for the FED, Asha Bangalore of Northern Trust notes of the important variables accompanying the latest rate cuts (highlight mine),

``Why did the Fed change the discount rate and not the federal funds rate? Discount rates are established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. Today’s change in the discount rate was an official request from the Federal Reserve Banks of New York and San Francisco. There is no special significance to the fact that it was requested by only two banks. In addition to lowering the discount rate, the Fed modified the term of the loan. The Reserve Banks’ usual practice is to make funds available overnight through the primary credit program. Today’s announcement noted that financing is available for long as 30 days and it is renewable by the borrower. The Fed also increased the range of assets that will be acceptable as collateral under this arrangement compared with that of open market operations. These provisions indicate that the Fed strongly believes that addressing the problem of liquidity is the top most priority. The Fed has chosen this route given the difficulty in estimating what banks’ demand for excess reserves are on a regular basis…the Fed has erred on the side of supplying too many reserves rather than too few, with the daily effective federal funds rate trading below the FOMC’s target of 5-1/4% in the past several days. In sum, this innovative procedure under exceptional circumstances has given the Fed flexibility and bought time to evaluate the situation.”

Essentially what we see from the FED are two factors, first a telegraph that they are open to provide a BID on risk assets to support the markets, and second, if the present nostrums don’t do its expected job, they’d throw the kitchen sink to the markets to prevent economy from going under regardless of risks of “moral hazard”.

Once again it appears that based on political incentives, monetary authorities are responding by effecting treatment based solutions than preventive ones. As such, they are unlikely cures for today’s imbalances.

US Markets: Unlikely A Reprise of 1998

``The good times of too-high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, . . . . there is a happy opportunity for ingenious mendacity.” Walter Bagehot, Lombard Street (p. 158)

Figure 6: Economagic: FED Cut case of 1998 versus 2002

The bulls argue that today’s actions has a precedent; the 1998 scenario. Then the FED applied its FIRST AID kit during the Long Term Capital Management (LTCM) induced liquidity crisis, where following the monetary treatment, its financial markets take off, as shown in Figure 6.

The leftmost red arrow shows of the FED cuts (red line) in response to the drop in the S&P (blue line) to our threshold levels. The S&P bottomed out in 3 months following the monetary remedy and speeded away for good.

However, this looks like apples to oranges comparison.

As seen above US economic growth (yellow green line) remained robust even during the selloff and looked unaffected. Second, US households and the global financial system were not as leveraged as it is today. Third, the source of stress came from external forces, following the 1997 Asian Financial Crisis. Russia went into a debt default which collapsed the highly geared LTCM run by two Nobel Laureates. And following the back-to-back crisis outside the US, money flows appeared to have shifted into the US markets which seems to have boosted the US dollar (green line), aside from its equity markets.

Today, the US economy has been growing below its average trend, US households have been levered to the eyeballs, the global financial system has exploded in size due to excessive leverage (the size of derivatives at $415 trillion is mind boggling enough!), global current account imbalances ballooned to record levels, and most importantly, the source of the present stress emanates from the US.

Fundamentally speaking, we don’t buy such arguments. However, we would keep an open mind and base our judgments on how the markets, especially the financial benchmarks, RESPONDS to the central bank impelled stimulus.

The bullish side critically DEPENDS on the central bank medicines to restore the present order. The bearish side is that central bank actions have always been SHORT-TERM in nature, and yet could go awry, as in the tech bust in 2000 (top red arrow). Besides, such inflationary actions usually involve longer term unintended consequences.

Finally, it is unlikely that a healing would occur soon. Even under the optimistic 1998 scenario, it took a QUARTER from peak-to-trough before a bottom was found. We are only about a month into this correction. It is too soon to tell.

Remember, NO trend goes in a straight line. There will always be massive relief rallies or bull traps within bear market cycles (refer to the Phisix 1997 chart). The latest Fed activities are likely to feed into the bullish insurgencies, but if problems continue to weigh on the financial system then eventually this would falter anew. Take such opportunities to exit instead as the risks prospects remain high.

Teetering At The EDGE Of A Market Meltdown, Global Central Banks To The RESCUE!

``Financial panics don’t happen during depressions…They happen on the brink of depressions. The claim the world is prosperous is beside the point.”-James Grant, the editor of Grant’s Interest Rate Observer.

In a span of 48 hours, global central banks in an apparent series of coordinated moves, under the threat of a market meltdown, conducted the LARGEST open market operations to inject liquidity into the world’s financial system since September 11, 2001.

The European Central Bank initiated the actions following a dramatic spike in overnight interest rates seemingly in reaction to a freeze on investor redemptions by France’s largest bank BNP Paribas on three of its investment funds that were invested in asset-backed securities (ABS) with significant exposures to US subprime mortgages. Asset backed securities is a type of bond collateralized by the cash flows from a specified pool of underlying assets (wikipedia.org) such as credit cards, auto loans and etc.

According to the Washington Post, ``The bank injected the equivalent of $84 billion into the financial system Friday "to assure orderly conditions in the euro money market," it said in a statement. The Federal Reserve added $38 billion to markets, the Bank of Japan $8.5 billion and the Reserve Bank of Australia $4.2 billion, signaling broad concern among central bankers. On Thursday, the European bank made a $130 billion infusion and the Fed added $24 billion.”

From Scott Lanman and Christian Vits of Bloomberg, ``Central banks in Norway and Switzerland also injected money into the financial system and countries including Denmark, Indonesia and South Korea said they're ready to provide cash.”

Let us hear from BNP Paribas the reason it suspended withdrawals (highlight mine), ``The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

Figure 1: New York Times: Spike in Interest Rates and Risk Aversion

Figure 1 from New York Times demonstrates how the markets suddenly seemed to have suddenly lost access to funding aggravated by a reversal in sentiment which appears to have raised risk awareness. How market psychology can swiftly change with a snap of the finger!

For instance, even when the FED rate is pegged at 5.25%, Bank of America had to add for its reserves last Thursday at 6%! In other words, because of the need by some banks to immediately secure reserves, they had to aggressively bid up the price of money. And only from open market operations by the FED did it normalize the rates.

This illustrates the implied “tightening” seen in the financial system as a consequence to the previous easy money policies which have likewise spawned financial engineering that resulted to the excessive leverage and speculation. The New York Times quotes Mr. Robert Barbera, the chief economist of ITG, a research firm (highlight mine), ``The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact…The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”

Now what used to be restricted to the confines of US mortgage lenders have now spread to the entire spectrum of international finance; from hedge funds to insurance companies (AIG) and now to banks! As Chris Hancock of Penny Sleuth aptly describes (highlight mine), ``The fear seems to be… No one really knows what these collateralized debt obligation (CDOs) are really worth. No one really knows who owns what. A farmer in France knows he holds a pension, but what that pension may be worth is anybody’s guess.”

Again this has not been limited mortgage issues as the credit woes has spread to the broader financial market, this excerpt from the New York Times (highlight mine), ``High-quality bonds issued by companies with sterling credit have not been immune to the rout either. Investment-grade bond issues fell to $30.4 billion in July — the lowest monthly total in five years — from $109 billion in June, according to Thomson.”

And since even the highest quality debts instruments had not been spared from the snowballing liquidity crunch, the diminishing appetite to take risks has started to curb activities even in the NON-FINANCIAL world.

In Asia alone, FinanceAsia identifies some of the emergent symptoms (highlight mine), ``Sure enough, Pakistani textile and fertilizer manufacturer Azgard Nine’s scheduled $260 million offering was postponed on Friday. Other companies in the pipeline such as Chinese property developer Hong Long Holdings, Indonesian mobile phone operator PT Mobile-8 Telekom, and Indonesian power company PT Cikarang Listrindo are also likely to experience considerable difficulties clearing their high-yield transactions. Nevertheless, chief investment officer Asian fixed-income and portfolio manager at Fidelity Funds, Andrew Wells says that credit spreads on Asian high-yield securities are now lower than for US high-yield. This indicates that investors view US high-yield as more risky than Asian high-yield.”

Naturally, with the epicenter of the credit tremors situated in the US, the perception of risk seen in the Asia-US yield curve is to be expected, although the contamination of the recent deterioration of credit conditions has obviously diffused to a broader segment of the global economy.

Ok, the basic dilemma in today’s setting is that with the recent financial alchemy, many portfolios of financial institutions around the world contain HIGHLY LEVERED instruments that are NOT openly traded or are highly illiquid. Such instruments in the past valuations had been DETERMINED by the ratings assessed by the credit rating agencies or by institutions that sold or distributed these, known as “Mark-to-Model”. Simply stated, many financial institutions who bought into these presumed that the US housing market had only ONE direction, never questioned on the financial INCENTIVES of the agencies that sold these products and most importantly never CONTEMPLATED on exit strategies or contingent actions arising from a reversal in the markets.

Now recognizing that some of these investments have been INFECTED by the US subprime problems, these financial entities are at a loss on how to value them since these have not been priced through the open markets. Since as we previously said, that losses on such levered positions necessitate margin calls, the corollary to this is the “COMMON FACTOR PROBLEM” where these financial institutions had no option but to sell assets that are most liquid (stocks or high quality debt) to cover their margins or borrow from another institution, ergo the contagion.

Moreover, there is the issue of RATING CREDIBILITY, some of the recently engineered financial products had been an amalgamation of inferior products (e.g. subprime) with that of mostly high quality debt products and had been eventually RATED as high quality ones. In short, there is also the issue of implied deceit or chicanery.

Considering the mounting losses, credit agencies have effectively been DOWNGRADING on a slew of such instruments, where markdowns constitute REVALUATIONS of portfolio values. For the others, losses would translate to large “haircuts” or even insolvencies. Therefore, one can expect losses on MORE institutions to crop up, and credit spreads to rise, as portfolios get “re-priced”. We borrowed Dennis Gartman’s quote last week, there is never one cockroach, now it appears that cockroaches have been appearing worldwide.

Essentially, all these show that many are today paying for the price of GREED, which had been stimulated by government inflationary monetary policies.

And because of the current dispersion of risk products into a WIDER pool of investors globally, the predicament of not knowing the worth of their portfolio assets have likewise led to the CLOSING of some credit channels and thus the liquidity crunch driven market carnage.

This is a very important germane insight lifted from the Financial Times (highlight mine), ``Marc Ostwald, fixed income strategist at Insinger de Beaufort, said: "There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas' statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch."

So fundamentally we have a crisis of confidence brought about by too much leverage that has incited to this panic. This is how Walter Bagehot in his book Lombard Street described panic (highlight mine), ``A panic grows by what it feeds on. . . . . A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. . . . . In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure, which causes them.”

If you think that the recent activities of global central banks will ARREST this unfortunate development, THINK AGAIN. Even as the ECB infused massive doses of liquidity to its starved markets for the second day, Washington Post describes the Friday’s outcome, ``European stock markets tumbled sharply. London's FTSE 100 index lost 3.7 percent, its largest drop in four years; France's CAC 40 fell 3.1 percent; and Germany's DAX dropped 1.5 percent.”

Yes, the US markets did rally from the chasms to close marginally lower (on Friday the Dow dropped 213 points but closed 31 down), but I highly suspect that these had been due to possibly more direct intervention from the President’s Working Group or as wikipedia.org explicates of the said highly secretive agency, ``The Group was established explicitly in response to events in the financial markets surrounding October 19, 1987 ("Black Monday") to give recommendations for legislative and private sector solutions for "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence" or subtly known as the Plunge Protection Team. But conspiracy theories are not our cup of tea.

The IMPORTANT POINT to understand is that with the series of seemingly coordinated government interventions around the world, such underlying motions acknowledges the severity of the problem largely underestimated by the world financial markets. The markets are only BEGINNING to adjust to the realization that they had applied leverage to the extreme levels, conditioned by monetary stimulus, which has resulted to the overestimation of business conditions or malinvestments in the terminology of the Austrian School of Economics. And it appears that the credit expansion cycle has turned.

In addition, since the present credit woes emanates from the US housing markets, then the ongoing HUGE ARM resets (as previously discussed) are likely to continue to hound the financial markets as foreclosures accelerate.

A further growing downside risk is that the US economy could enter into a RECESSION soon as consumers (estimated 76% of GDP) get tapped out from a 1-2-3 combo punches of DECLINING asset values of real estate and stocks and FESTERING credit conditions unmatched by any significant improvements in business investments and/or employment conditions, enhancing the odds of more downward financial markets readjustments.

Recently the US FEDERAL Reserves in its FOMC maintained that inflation was their main concern as a reason to maintain its present rate level. This will change soon.

Even hawks like St. Louie FED President Mr. William Poole, who recently denied that the FED would come to the rescue of the markets, or of FED Chief Ben Bernanke and US Treasury Secretary Paulson, both of whom claimed that the subprime worries would be limited have proven to be wrong, as rhetoric has NOW given way to palliatives.

The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon. And if the FED enacts a series of cuts, this underscores the risks of what we had mentioned above.

During the last two days, unknown to the public, the world financial markets teetered at a brink of a collapse.

Analyst John Maudlin quotes anonymously a financial expert (highlight mine) who piquantly describes the present situation, ``We came to the edge of the abyss in the financial markets this week, and then we looked over. The world does not understand how close we came to a total meltdown of the markets.”

A “Normal” Correction in the FACE of Massive Government Interventions? No Can Do!

``Mankind is condemned to repeat history, the first time as tragedy, the second time as farce.”-Karl Marx (1818-1883), German political philosopher and economist

I find it comical to see some analysts or experts completely in DENIAL to the present circumstances. Some see the present opportunities as a buying window, where they suggest that the present correction runs a “normal” course of action to the underlying trend. This runs contrary to common sense.

We pointed out that since global monetary authorities concertedly acted to salvage the present liquidity drought induced crisis, the fact that they ACTED on a supposed problem reflects a deeper degree of that problem than what had been mostly assumed. Yet, in the face of the synchronized central bank support worldwide, the continued violent reactions in the market in itself represents strong evidence of a fallout from such existing malaise.

In technical terms, yes, the correction in the US markets is within NORMAL ranges until now. But NO, you don’t see global central banks injecting liquidity regularly in the markets, do you? The last time they lent this degree of support was during the infamous September 11, 2001, which obviously means that the present imbroglio has even had MORE impact than 9/11, since today’s rescue package had been much larger in scale and scope (worldwide)!

NOW if the FED further acts to cut interest rates, which I expect to be very soon, (in a month or even less perhaps, depending on how the markets react), then such action should be construed as the recognition of Mr. Bernanke and Company of the imminence of the risks of degenerating economic conditions in response to the self-imposed tightening brought about by the continuing recession in the US real estate industry, which has now spread to other segments of the economy. This should imply that US markets may have FURTHER room to fall!

Ok let us revert to some technical standpoint to see how “Normal” things are.

Figure 2: Chart of the Day: September is the Worst Month for US Markets

Chartoftheday.com totaled the monthly average performance of the US major benchmark the Dow Jones Industrial Averages since 1950, as shown in Figure 2 and arrived at the statistical probability that going forward September could equal its WORST performance as it had been in the past 57 years.

This means that as August (barely changed from July 31^st) progresses which seem to be acting out an inflection point, September could even deliver more sufferings to the rear view mirror looking bulls. So essentially why take the risk today unless there is a tradeable short term window (but again risks prospects are high)?

Figure 3: BBC: Market Crashes Through The Ages

Two charts I compiled from BBC as shown in Figure 3 is the 10 biggest ONE DAY FALLS (leftmost bar chart) and 10 worst BEAR markets (rightmost bar chart) in the Dow Jones Industrial Averages.

Notice on the left chart that the 10 biggest declines had occurred mostly during October (5 times) followed by August (2 instances).

So aside from seasonal weakness for the month of September, August until October has proven to be a quarter previously SENSITIVE to the biggest one day losses for the Dow Jones. This implies that if HISTORY would ever rhyme again, then the present quarter has INCREASED the odds for the Dow Jones to be equally SUSCEPTIBLE to a HUGE one day decline!

Moreover, if today’s market has turned out to be an inflection point rather than a “normal” correction then the rightmost chart tell us that the average bearmarket in the US falls by around 40%!

And since our Phisix and most of the global markets has closely traced the movements or have been POSITIVELY CORRELATED with that of the US markets then think of WHAT a bearmarket in the US might possibly do to us or to the global markets, as shown in Figure 4.

Figure 4: The Previous Bear saw the Dow Jones HURT the HANG SENG and the PHISIX

When the 2000 tech bubble imploded in the US, the Dow Jones (black candle) plunged to about 7,200 (2002) from a high of about 11,900 for a 40% loss, as shown by the green trend channel.

In a similar timeframe, coincidentally the Hong Kong’s Hang Seng Index fell by about 52% (blue line) and the Phisix (red line) an even harder 62%!

And when fundamentals and technical viewpoints match, they tend to deliver quite a meaningful impact!

Of course I can always be wrong (which I hope I am--it will be a financial drought anew for us in the industry under a bearish environment--I should perhaps look for a new job).

Maybe confidence will be regained soon (I hope), the liquidity drought reverses and recovers (I hope) and credit conditions will ease (I hope) as the housing recession in the US finds a bottom (I hope).

But as a student of risk and market cycles, I wouldn’t bet on HOPE UNTIL the market proves me WRONG by stabilizing and eventually recovering. For the moment, this OBVIOUSLY isn’t the case.

Our goal is to preserve capital first and foremost.

Why Cutting Losses Is Better Than Depending On Hope

``Good traders, we think, don’t stand around and tell you how wonderful they are when they are right; most of time good traders only talk of their losers. Good traders’ reverse the natural tendency to attribute winning trades to brilliant analysis, and losing trades to bad luck; they understand what Livermore meant when he said, “In trading its better to do right, than be right.” The functional reality of this type of mindset is to limit the ego—which wants to seep in and control all.”-Jack Ross Crooks III, Black Swan Capital

Well to all those who still insist on clinging to the “ladder of hope” on this apparent monumental shift in market directions, I’d offer you a simple arithmetic which would enable you to reassess on your commitments.

Table 1: Returns Required to Break Even

Table 1 tells us that IT TAKES MORE EFFORT for the bulls to recover from their losses than to take losses and wait for the opportune moment to reenter the market.

For instance, a loss of 25% requires 33% in gains to offset the nominal losses (excluding transaction costs-which mean gains should be even larger). Similarly, a 50% loss translates to 100% (++) of gains in order to reverse the losses. As the losses worsen, so does the magnitude of gains required to neutralize such losses.

To sum it up, taking action by minimizing losses is A LOT BETTER than foolishly indulging in the hope of a recovery. As we always say, financial markets are mainly about opportunities management which should incorporate rationalizing costs relative to benefits.

Phisix: Undergoing A Cyclical Bear Market Within A Secular Bull Market Cycle?

``Over every mountain there is a path, although it may not be seen from the valley." - Theodore Roethke (1908-1963), American Poet

Finally, I think it is NORMAL for any countercyclical trend to operate within a structural long term trend. Because NO TREND GOES IN A STRAIGHT LINE, this means that a cyclical bear market can function WITHIN a secular bullmarket.

The Phisix has not been INSULAR to such circumstances, as shown in Figure 5.

Figure 5: Chartrus.com: Phisix had two 50% decline in the last bullmarket!

During the last secular bullmarket phase in 1986-1997, the Phisix encountered TWO cyclical bearmarkets, marked by the two arrows, which was evidently triggered by the two coup attempts of August 1987 and December 1989.

In between these reversals, the main Philippine benchmark lost by about 50-60%. Yet, this did not stop the Phisix from reaching the 3,400 level in 1997!

In the meantime, the present correction looks to me more like a typical countercyclical trend, under abnormal circumstances.

In the condition that the world does not fall into a DEPRESSION, I believe that the other MAJOR risk for my Phisix 10,000 is PROTECTIONISM.

The former is a risk that the global financial market has to FACE TODAY (why do you think global central banks intervened?) while the latter could be SUBSEQUENT to the former, as further losses could translate to escalating calls for MORE government intervention to assuage or mitigate their losses.

In short, the voting public will STIPULATE short term solutions in exchange for longer term unintended consequences and authorities will, in most probability, based on political incentives deliver it to them.

You should watch TV personality James Cramer go ballistic in a CNBC TV program captured in YouTube with his demand for the FED and Mr. Bernanke to immediately intervene during the latest bloodbath. We expect to see more of these hysterics from a broader field of market participants as the markets gets tested to the downside.

http://www.youtube.com/watch?v=cYPtCmdFCrc

Instead of entrapping ourselves with emotions that result to outbursts and tantrums which does not effectively relieve us of our losses, we should learn, understand and implement portfolio strategies on the premises that financial markets operate on cycles, which is the MOST important lesson I’ve learned on the markets throughout these years.

Technical View on the Phisix: The Path of Least Resistance is Down

``At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way...When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance." Chuck Prince, the CEO of Citigroup

At the start of the week, I was recently asked by a reader at my blog, if this signals the end of the global bullmarket.

To which my reply was, “As Scottish Philosopher Thomas Carlyle once wrote, ``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.

“What lies clearly at hand is the violent reactions seen in the world markets.

“If in the past, world markets have been buttressed by the abundance of liquidity, what appears to be a drag to the markets today is exactly the opposite.

“My understanding of the markets is that we are faced with serious headwinds and in my case would necessitate to react accordingly.

“If it is just a bear trap, then opportunities will allow us to earn again.

“If our fears translate to market mayhem then we'd be sulking on losses on a ladder of hope.”

Moreover, we’ve been asked if these developments could be indicative of a possible end to the recent streak of losses or a potential bottom which could present itself as a buying opportunity. Albeit in most instances, most of our queries manifested signs of consternation (beneath the surface) on the unfolding events in the markets.

The investing public is today groping for an answer on what they think as unseemly. Some have even attributed domestic political events as possible causes, which we believe are entirely irrelevant. Such is called the information bias - the tendency to seek information even when it cannot affect action (wikipedia.org) or the “Narrative fallacy” – our need to fit a story or pattern to a series of connected or disconnected facts (Nassim Taleb).

And yet there are those who have come to believe that every action in today’s market postulates a replay of the recent past (anchoring), or that recent countertrends will ONLY pose as buying opportunities as in February of this year (corrected by about 12.5% peak-to-trough), May 2006 (about 19%) or March 2005 (about 16%), where possibilities that our Phisix has entered into a cyclical bearmarket (within a secular bullmarket) has been ruled out.

Could this be a bottom? Yes it could. Could this be a buying opportunity? Perhaps, but I certainly wouldn’t bet on it.

Technically speaking, the Phisix from its July 13^th zenith at 3,820 has corrected by about 12.5% (peak-to-trough-assuming that the recent low is a bottom; again I wouldn’t bet on it). So essentially the recent market actions have been in line with its normal comport, which gives the bulls their confidence to declare a bottom.

However, we must be reminded that the Phisix has been largely DRIVEN by global money flows which have in MOST occasions reflected on the actions of mainly the US markets and the secondly the US dollar.

Put differently, we shouldn’t depend on the technical picture of the Phisix, unless our benchmark has concretely manifested signs of independence or distinction from the movements of the world equity markets. As we always say, a correlation is a correlation until it isn’t!

Figure 1 stockcharts.com: World Markets Breakdown!

And world markets have been showing formative signs of breaking down from medium term support levels as shown in Figure 1!

The US S & P 500 (at the topmost pane), the Dow Jones WORLD index (above pane below center window), and the Dow Jones Asia Pacific Index (lowest pane) have recently, similar to our Phisix (main window), broken below its key support levels.

With the fresh breakdowns in the international arena, momentum implies that our Phisix could likely be further affected. My conjecture is that the Phisix could possibly test the 3,200 level soon marked by the 200-day moving averages seen above, as the decline in global markets could accelerate. A break below 3,200 delivers us to the bear territory.

Not to be accused of data mining or selective reporting, we should equally note that emerging market indices are at present perched at similar key support levels BUT HAVE YET to breakdown as its peers. Our hypothesis on this divergence: since China’s market has been defiant of this global trend (e.g. Shanghai Composite index up 4.96% week-on-week, and 70.46% year-to-date), this has cushioned the declines reflected in the key emerging market indices.

Now, if one believes in the maxim that “a trend is our friend” then manifestations of these vital transgressions suggest of a REVERSAL in the bullish sentiment. In short, the burden proof now switches from the bears to the bulls, where the path of least resistance is most obviously down.

Well of course, given the recent rout we cannot discount the possibility that the market may undergo some technical bounce. However, we shouldn’t take this as signs to favor the bulls back in fashion unless key resistances will have been taken out.

I have been indisposed to take much of the required actions simply because I wanted to see added confirmations from overseas. However, the activities in the domestic market have been climactic.