A Global Depression or Platonicity?

``A novel, a story, a myth, a tale, all have the same function: they spare us from the complexity of the world and shield us from its randomness. Myths impart order to the disorder of human perception and the perceived “chaos of human experience.””- Nassim Nicolas Taleb- Black Swan, The Impact of the Highly Improbable

This leads us to the next topic: global depression.

Major deflationist advocates argue that since the US economy is the sole consumption engine of the world, the transmission of potential debt defaults or credit destruction through the finance and trade channels would lead to a global depression. The Japan’s LOST DECADE scenario is the most frequently cited example.

And global depression means significantly higher US sovereign bond prices or lower yields and a rising US dollar. All other asset classes are likely to struggle including gold (although some deflationist argues counter-intuitively that gold will prosper under such scenario).

Let me first say that in the financial markets anything can happen. Therefore, extremities as a FED prompted “magic” or global depression could also occur and we don’t discount these. But to my opinion, the weightings I would assign for such probabilities would be in proportion to the logic in support of such arguments.

First of all, while it is true that the US FEDERAL Reserves and the other global central banks may not be able to “stop” deflationary forces our question is the US the world or the world the US?

In his book, Black Swan (incidentally my textbook) Mr. Nassim Nicolas Taleb describes “Platonicity” as (highlight mine) ``our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”

Let us take for example some ingredients of the present crisis, such as Collateralized Debt Obligations or CDO or a type of asset backed security and structured credit product which pools several collateral including mortgage securities.

Figure 2: SIFMA: Global CDO Issuance Market Data

One of the attributions to the present seizure in the global financial system has been due to the opaque valuations of the said highly levered and illiquid instruments.

Figure 2 from SIFMA tell us that up to 76% of CDO issuances in 2006 and 75% of 1^st half of 2007 have been US dollar denominated.

Since the US mortgage market is about $6.5 trillion (about $1.3 trillion are subprime), many of these securitized mortgages make up the tranches pooled within these CDOs, and as we previously mentioned…sold and distributed worldwide.

The predominance of US CDO issuance is a testament to the degree of leverage faced by the US financial system relative to the world.

Figure 3: IMF: GFSR Global Hedge Funds by Geographic Source of Funds

Hedge funds are said to be one of the major investors of CDOs, according to the Bloomberg, ``About 25 percent of the trading in U.S. asset-backed securities was done by hedge funds. They were responsible for 20 percent of the volume in mortgage-backed securities trading.” (highlight mine)

In figure 3 courtesy of IMF, while the growth of the hedge funds industry have been worldwide leading to a reduction of the share of US based institutions, what we want to point out is that if there will be any destruction of credit, the bulk or meat of the damage would likely still be in the US, where 62% of hedge funds are located.

Of course, hedge funds and CDOs don’t make up the entire investing sphere, but what we would like to point out is that deflationist school of thought overestimates the universality of the global credit structure. Such view is ultimately too US centric.

The problem of “foreign currency reserve rich” Asian countries has been as BUYERS of these tainted instruments which could result to some balance sheet losses but should not affect its economic functions in the entirety.

FinanceAsia interviewed ANZ's Melbourne-based chief economist, Mr. Saul Eslake, from which we quote,

``Asian investors and financial institutions will have some of this toxic debt on their books. And will have to confess to how much they have lost. But I doubt there are many institutions in Asia – that matter – whose fundamental stability will be put at risk by those losses. In a sense, Asia has spent the last 10 years taking out insurance against the events that laid Asia low 10 years ago – and that will insulate Asia from some of those things. But people who write insurance, take a hit when claims are made, and that is effectively what is happening at the moment.

``But as far as the Asian economies are concerned they should be resilient. If there is a recession in the US – it is not more forecast, but it is a risk – then there will be adverse consequences for economic growth. But what we are talking about is maybe a percentage point off Asia’s growth rate, not a recession.

``As far as Asian equity markets are concerned: if the central banks succeed in restarting the credit mechanimsm, part of the means by which they will do that is by cutting interest rates. Lower interest rates, combined with what is fairly good growth, should be good for Asian equity markets, particularly since – China aside – they are not really overvalued.”

Figure4 BIS: Median debt equity ratios

We think ANZ’s Paul Eslake makes a good point to rebut against a global depression. Figure 4 from Bank of International Settlements tells us how deleveraged Asian economies are following the Asian Crisis.

Quoting the BIS on their latest quarterly outlook (highlight mine), ``The situation improved significantly after the crisis. Beginning in 1998, leverage began to fall significantly for Korea and Thailand, with book (market) leverage dropping to 77% (76%) in Korea and 99% (52%) in Thailand by 2005, well below pre-crisis levels. At the same time, interest coverage ratios improved markedly to above pre-crisis levels in all of the crisis countries except the Philippines (Graphs 1 and 2). By 2005, much smaller percentages of firms in East Asian countries had an interest coverage ratio below 1. Only in the Philippines was the percentage of firms unable to cover their debt service still relatively high, at 13.5%.”

Second, is that depression advocates argues in the context oblivious of the existence of today’s Fiat currency Standard.

What we mean is that the US Dollar being the world’s de facto currency standard would require the US Government to fight tooth and nail for the sustenance of present system, which underpins its quintessential pride and dignity.

It could, under present circumstances coordinate with global central banks to institute measures to mitigate the present junctures circumstances as what we have lately. What used to be national is today global, such is the marked nuance.

Yes while there is no guarantee that these efforts would work, synchronized moves could allow central banks more arsenal at their disposal. In other words, the inflationary system could last longer more than what the depression advocates may think of.

Further global central bankers appear to operate under the concept of the game theory called the NASH equilibrium, from which we quote the old article of one of my favorite analyst John Maudlin (highlight ours),

``The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.”

Put differently, in the eyes of central bankers, there is less of an incentive to upset today’s conditions, regardless of the imbalances built under the present setup. Hence, they would probably attempt to work for the status quo, while gradually attempt (or at least pay lip service) to deal with the imbalances —the NASH equilibrium!

Third, the financial markets are not limited to reflect on the economic domain but transmissions of monetary policies…

Figure 5: zse.co.zw: Soaring Zimbabwe stocks!

Zimbabwe is a functional example. The economy is undergoing recession if not depression, suffers from 7,000% of hyperinflation, have a chaotic political order…BUT a SOARING STOCK MARKET! See Figure 5 from the Zimbabwe Stock Exchange.

We discussed this in our April 9^th to 13^th edition [see Zimbabwe: An Example of Global Inflationary Bias?], our point is, regardless of the economic situation, inflationary activities by central banks could lead to leakages elsewhere (in any asset classes) in this globalized world.

Maybe under a PROTECTIONIST or “closed” world order, the depression scenario could possibly have more clout.

Lastly, the Japan LOST DECADE scenario has been the frequently cited case of the deflation disorder, where Keynesian infers this phenomenon as the “liquidity trap”-- ``that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant because money and bonds are essentially perfect substitutes (Paul Krugman)”—allegedly responsible for over a decade of economic slump.

The peculiar thing is that Bank of Japan has followed to the hilt the prescriptions of its Keynesian and Monetarist mentors to no avail--from exhaustively heaving up of public spending (which today led to the largest public debt among developed nations 176% to GDP -CIA, 2006 est) to adopting monetary policies as Quantitive Easing.

Of course, there are some extreme and elaborate distinctions; culturally, Japanese is the world’s biggest saver against the US which is the world’s most spendthrift nation. So a comparison is definitely an apples-to-oranges one but since our discussion covers the globe, depressionists suggest of covering of the entire basket of fruits.

Second, the polemics boils down to the valid analysis of the present conditions.

We quoted self-development author Robert Ringer in his article “Beware of False Perceptions” in the past (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.”

From which we question, “could the liquidity trap theory be erroneous if not fallacious?”

The Austrian School through Chris Mayer disputes such widely believed theory, we quote at length (emphasis mine)

``Many are those who believe Japan is or was in a "liquidity trap." The basic idea is that people's "liquidity preference," or their demand for cash, is so high that the interest rates cannot fall low enough to stimulate investment. The basic Austrian criticism of the liquidity trap concept is that it has the causation backwards. Interest rates do not drive investment.

``As Murray Rothbard points out in his book, America's Great Depression, "saving, investment and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with it." In other words, the consumers' choices drive the rate of interest—not vice versa.

``Other analysts obsess over the "deflation problem." The idea that deflation is the villain of the piece misses an obvious fact: money supply continues to grow. However you slice it, be it M-1, M-2 or "broadly-defined liquidity"—they have all been growing every year since 1984, the earliest date provided by the BOJ data bank on its website. M-1 grew 8.5% in 2001, 27.6% in 2002 and 8.2% in 2003. M-2, a broader index, grew 2.8%, 3.3% and 1.7% in each of these years.”

The St. Louis Fed has charts on Japan’s growth of monetary aggregates click on the link to prove Mr. Mayer’s point.

``Deflation proper—a decline in the supply of money—clearly has not happened. Prices, as measured by the current fashionable indices, have fallen, but that is not a deflation—no more so than our current mild CPI readings measure low inflation. But even so, the Japanese consumer price index decline has been quite mild. According to the Japanese Statistic Bureau, the Japanese CPI stood at 98.1 at the end of 2003, a decline of 0.3% from the prior year (the base year, 2000 = 100).”

Again click on this link from the St. Louis Fed on Japan’s Inflation (Consumer and Producer Prices).

``It seems to defy common sense to suggest that the problem with Japan is the small annual decreases in its CPI. Surely, if a mild 1–3% increase in prices is acceptable to mainstream economists, then a decrease of less than 2% ought to pose no dire problems. Mainstream economists insist on treating price deflation as if it were some unholy beast and inflation as some manna of prosperity.

``The central problem of Japan is not a liquidity trap and it is not deflation—the fundamental problem is a pattern of production ill-suited and ill-fitted to meet the realities of the marketplace.

``In general terms, the Japanese wanted to protect their exporters, despite the fact that the marketplace had changed and moved against them. They wanted to persist in the belief that the blue chip debtors of yesteryear were still creditworthy. The Japanese economy was like a shopkeeper in denial of what his customers were telling him. Pretending not to hear it, he goes about his daily business as before only driving himself further into losses.”

Yes, mainstream analysts today espouse the view that Japan is under deflation. This prevalent thinking represents an oversimplified “platonified” explanation of developments even when they even don’t MEET THE TECHNICAL DEFINITION.

As Robert Ringer suggests above, misdiagnosis leads to the wrong cures or even worst, possibly a cure worst than the disease. The anatomy: False perception leads to false assumptions, which then leads to false conclusions thereby rendering negative results on the actions applied.

Obviously Japan’s policymakers in refusal to lose power and privileges to free markets adopted the backward process of thinking or the “rear view mirror” syndrome to apply ineffectual policies that have prolonged the slump.

It goes the same with investment analysis…

A FED induced economic and financial markets turnaround and…

A global depression operates on a common thread…

They are based on Nassim Taleb’s “Platonicity”- makes us think that we understand more than we actually do- or…

OVERESTIMATING what we know and UNDERESTIMATING on what we don’t. We don’t give room enough for randomness but rather play up on our biases.

Which is why we give weight to the second probability, a potential recessionary risks coupled with open ended global outlook…

Loosening Correlations: A Possible Reprise Of The 1970-80s “Stagflationary Era”?

``The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists."-Ernest Hemingway, September 1932

When we try to distinguish from what could be real and what could be an illusion, we do this by listening to the markets or heeding on the messages transmitted by the markets.

So what does the markets tell us today?

Figure 6 tell us that we are at a crossroads as seen with several breakouts.

First, the US dollar trade weighted index has officially closed BELOW the 80 level (see topmost pane), a multi-year low (!), following the weakest Jobs report since 2003 as discussed above. We previously discussed this last July 9 to 13 [see US Dollar Index Sits At Multi-Year Lows, Risks of Disorderly Unwind Heightens] and in July 16 to 20 edition [see US Dollar Index At 35 Year Support Level; Gold is Your Best Friend Now].

Second, aside from rampaging grains and rising oil, gold BOLTED out of its 6 month trading range [main window] and seems on path to test May 11, 2006 high at $726 dollars.

Third, US treasuries as we have said above BROKE DOWN OF ITS SUPPORT LEVEL signifying the market’s expectation of a steep deterioration of the US economy.

Let me borrow an incisive explanation of Professor John Succo or Mr. Practical in Minyanville.com (highlight mine),

``This is why the Fed has lowered interest rates at the discount window (emergency room): private money is no longer willing to lend to banks holding crumbling and risky mortgage debt and the Fed and other central banks have become their only source of liquidity. Banks have little treasuries in inventory to exchange for new credit from the Fed; this is why the Fed is now accepting more and more risky collateral like mortgages and consumer loans. Ironically this may allow banks to not write down those assets to market prices: they exchange in REPO those assets at some artificially high price and the Fed carries it at that price through the term in the REPO.

``If the REPOs are continually rolled, the banks may not have to take losses on those assets for some time. If this is so (I am investigating this), it is just another shell game to buy time. In trying to get normal longer term funding, I know of a sterling deal floated by a major European bank that failed; it pulled the deal and funded through Euro debt at egregious terms (imagine what that will do to its earnings). This tells us, by the way, that it is not just a dollar debt problem (although dollar debt is by far the largest), but a global debt problem.

``A force weakening the dollar will be (may be acting now to a small extent) the final destruction of that debt manifested by foreclosures and prices of assets like land and houses (and yes, eventually, stocks) that act as collateral, falling domestically until foreign savings buys them at lower clearing exchange rate (this is likely to be much lower given the meager amount of world savings relative to dollar debt). It is when a significant portion of the dollar debt (I don't know the number) is destroyed (defaulted upon) that the forces working to strengthen the dollar are overwhelmed by the forces weakening the dollar. Remember, the dollar is not backed by real money, but by debt. When that debt is destroyed, the dollar becomes worth much less.

``This is when gold will rise precipitously against the dollar and other currencies as well. Those currencies backed by real savings will do relatively better.”

Borrowing the kernel of Mr. Practical’s exposition; the ongoing “debt destruction” in the US implies for a WEAKER dollar, which could be what we are witnessing today. Yes, there are reports that the China has initiated to unload some of its US treasury holdings, but the impact to further undermine the US dollar’s position depends on it’s the continuity of its actions.

And a weaker dollar means inflationary forces gaining an upperhand, despite the debt destruction “deflationary” process. The rise of gold, oil and grains could be supportive of this view. This also suggests of higher interest rates which possibly mean that the US treasuries could reverse, fall (rising yields) and undergo an inflection, even as the US economy deteriorates. This outlook goes distinctly against the views of depressionists.

Figure 7: Chart of the Day.com: September’s Travails

Earlier we stated that we are at the crossroads of possible formative major trends. If gold continues to rise alongside a weakening US dollar supported by flanking increases in the price of oil or other commodities in the face of declining US stock market and a potential US recession, then important divergences could be unraveling: a possible reprise of the 1970-80s “stagflationary era”.

Of course, one week does not a trend make, albeit Figure 7 (chartoftheday.com) tells us that September has been a cruel month for US stocks, today’s inspirational leaders for global equities including the Phisix. And it appears that events are playing out the September theme well.

Friday’s softening of the US markets in the face of an unexpected deterioration in the US job numbers could be the start of the unwinding risks of a US recession.

Recently, even authorities such as Reserve bank of St. Louis President William Poole see “higher chances for an economic downturn in the US”. Likewise former Fed Chair Alan Greenspan was even glummer with his comments comparing the present scenarios with that of the 1998 LTCM and Oct 1987 crash:

``The behavior in what we are observing in the last seven weeks is identical in many respects to what we saw in 1998, what we saw in the stock market crash of 1987"

Timesonline.co.uk quotes further Mr. Greenspan, `` The human race has never found a way to confront bubbles,” he said, suggesting that the manipulation of interest rates offers little control to central bankers.”

``Bubbles cannot be defused until the fever breaks.”

While we are not impressed by Mr. Greenspan’s forecasting capabilities, the fact that Mr. Poole and Mr. Greenspan raised the issue gives credence to the heightening risks concerns on the health of the US economy.

So what to do?

First, we need to spot for continued divergences. If the present weaknesses in the US markets persist on to spillover to global equity markets, then we remain on the sidelines.

Second, if, however, in the face of faltering US stocks, precious metals continue to rise (confirmed by rises in other commodities as oil and a weakening dollar) and likewise reflected in global mining issues, then a gradual reentry into the MINES should be considered.

Third, if, however, in the face of swooning US financials markets, global markets manifest of strong signs of decoupling then one should consider repositioning back to the general market.

Where we do not see any confirmations, we remain seated at the gallery.

Finally, I’d like to borrow Dr. Marc Faber’s conclusion from Tomorrow’s Gold (emphasis added),

``I am leaning toward the view that some sectors and regions will deflate-either absolute price falls or currency depreciation-while those already extremely deflated will rise in price. So inflation and deflation could coexist for quite some time. Moreover, it should not be forgotten that, even in a strong deflationary environment, some commodities and assets can appreciate rapidly as their respective prices are determined not by the overall macroeconomic price trends, but rather by demand and supply forces specific to their particular markets.”

A Correlation is a Correlation Until it isn’t…Time for that much awaited Break!

Global Equity Markets: A Complete Recovery or A False Dawn?

``But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by "backing" them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm's income and assets, not debts backed by dubious assets.”-Jeremy Siegel, Wharton University of Pennsylvania, Why Bernanke’s Critics Have it All Wrong

My apologies for initially posting the wrong chart, I'd like to thank reader Melvin for bringing this up...

The Phisix ballooned by nearly 5% this week, accounting for a dramatic 15% advance in only two successive weeks since it hit new lows last August 17^th.

Many had been seen cheering in the assumption that perhaps the ‘bottom had been found, the crisis had been averted and we are on our way to glory’, as it had been during the past 4 years.

As the previous corrections served as “windows of opportunity” to reenter the market, such occasions proved to be profitable engagements and thus had been programmed into the mindsets of our average investors that history is due bound to repeat itself.

Perhaps they could be right. But we simply couldn’t go along with such views because we understand that past performances does not always produce similar outcomes or we simply can’t be lulled into simplistic generalizations.

As proven by the recent turmoil, today’s financial markets have been closely intertwined. Imagine the woes of some real estate speculators in New York or elsewhere in the US similarly affects the security prices at Philippine Stock Exchange or even potentially the financial conditions of the “real economy” in the form of lending conditions to our entrepreneurs or farmers.

True enough the Phisix recovered a substantial segment of its lost ground as global equities appeared to have “stabilized” as shown in Figure1.

Divergences in Bond Markets and Equity Markets: Who’s right?

But beyond the horizon of the equity markets. the strains from the recent bouts of liquidity seizure or credit squeeze still has not been “normalized”--the very essence that has buttressed the financial markets in its entirety.

Figure 1: Stockchart.com: Recovery or Pause from Bloodbath?

As shown in the chart, world markets, represented by the Dow Jones World Index, at the lowest pane, alongside with the US S&P 500 (main window) manifesting some indications of recovery. Yet, just as global stocks initiated some convalescence, panic buying towards short term 3 month T-Bill US treasuries resulted to a PLUNGE in its discount rate last August 20^th, marked by the circle at the topmost pane.

Today, the short-term US treasury has like stocks, equally recovered some lost footing but still drifts below the breakdown levels.

Mr. Ambrose Evans-Pritchard of UK’s Telegraph has an interesting dramatized commentary last August 23^rd (highlight mine),

``Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month US Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before.

``Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies - (exposed as they are to short-term commercial paper and subprime CDOs). This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (it hit in August 1931). If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.”

Of course, this “flight-to-safety” can also be noted in the US 10-year treasury (seen in pane below the 3-month T-bills) whose yields have been on a DECLINING TREND even as global stock markets remained buoyant (Could the bond markets have presaged the decline in stocks?).

The yields of the 10 year instrument have traditionally been benchmarks of mortgage rates. But in today’s setting, mortgage rates remained high as a consequence to the growing risk aversion towards mortgage-related instruments and the tightening of lending conditions in the mortgage markets, while the 10-year benchmark yields has collapsed.

According to the Shobhana Chandra of Bloomberg, ``The average rate on a one-year adjustable mortgage surged to 6.51 percent, the highest since January 2001, from 5.84 percent the prior week. The rate also surpassed the cost of a 30-year fixed loan for the first time.”

The stampede towards the treasury markets are indications relayed by the bond investors that they expect a SIGNIFICANT SLOWDOWN or at worst a RECESSION.

Professor Gary North explains in his article “RECESSIONS ARE GREAT OPPORTUNITIES” last December why such market reactions are likely to be indicators of such events,

``This oddity appears before every recession. It exists because bond investors are generally a lot wiser than stock investors. They are mainly institutional buyers and rich buyers. They see what is coming earlier than stock investors do. When they see recession coming, they are willing to lock in their money for 30 years rather than get paid a higher rate for money tied up for 90 days. They think rates are coming down. They want to lock in high rates.

``Why should interest rates come down? Because rates fall during recessions. There is reduced demand for loans: fear of debt. There is also money flowing out of the stock market into CD's, T-bills, and simple bank accounts: fear of capital losses. People care more about the return of their capital more than the return on their capital.”

Equity Markets: Walking on Government Crutches

In addition, for last week, the gains from the US broadmarket bellwether the S & P 500 seems to have been bolstered by government led initiatives. Aside from the provision of contingent liquidity by global Central banks, there had been a barrage of jawboning from US authorities (see two arrows in Figure 1).

On Wednesday, following a hefty decline, Fed Chairman Bernanke announced that the FED would “act AS NEEDED to ease the impact of the credit squeeze” and the market almost virtually erased the losses overnight.

Friday was a follow through, but this time with US President Bush promising to respond to the unfolding crisis by helping those “affected” (proposed loosening up on standards from GSEs and allow for refinancing) saying this was not to benefit the speculators but aimed at helping the low income home-owners.

Meanwhile, at the annual FED symposium at Jacksonville Arkansas, its Chairman Ben Bernanke reiterated what it said Wednesday that the Fed ``will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets”.

Notice that under today’s circumstances, the global financial markets appear to be TOTALLY DEPENDENT on the actions of Global Central banks. Everyday the market looks for guidance from authorities, without which the market undergoes selling pressure. For instance, the Bush-Bernanke tandem has temporarily provided relief or the cushion required to sustain the US equity markets at present levels.

But financial markets ACT as a discounting mechanism, from which the present messages by authorities UNLESS TRANSFORMED INTO ACTIONS will likely become stale, discounted or ignored from where the risks of a selloff becomes of a larger probability.

In short, the markets expect the authorities to ACT on their promises to resolve the impasse otherwise a selloff becomes imminent!

Put under the previous analogy we used; like drug addicts, today’s market have been anxiously awaiting for requisite substance for them to continue with the party.

In another perspective, it is quite ironic why authorities would have to react to the present turmoil with utmost urgency, when the equity markets have taken a small impact. Consider, despite the present selloffs, the US equity markets remain positive year-to-date; the Dow Jones Industrial up 7.2%, the S & P 500 3.93%, Nasdaq 7.5% and Russell 3000 3.75%.

The answer appears to be premised on the chain of leverage embedded in the present financial system.

Many of the non-banking financial institutions like hedge funds have taken enormous amounts of leverage by as much as 10 times or more for every dollar of capital exposed. For example, a $100,000 position geared 10 times would translate to $1,000,000 in investment exposure--where a 5% gain is magnified into 50% return. That’s when the going was good.

Conversely, when the going gets tough, a 5% loss wipes out 50% off the capital or simply a 10% loss eviscerates all capital from those institutions with a 10 to 1 or more in gearing. Small moves get amplified with margin positions.

Subsequently, losses emanating from such levered positions impair the capability of such institutions to pay or settle with their creditors, who essentially takes a hit through a forcible expansion of the lending institutions’ liabilities and where operational losses mount. To paraphrase a saying, if you borrow 100,000 pesos from a bank, the loan is your problem. But if you borrow 100 million pesos from a bank, the loan becomes the bank’s problem.

In today’s landscape, an overdose of credit is the problem of the financial system.

This is could be ONE possible major reason why regulators have been overly alarmed by the losses from other markets which threatens to diffuse to an equivalent streak of losses in the equity markets.

The Essence of a Fractional Banking Reserve Requires A Bailout of the Banking System!

``From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other; and we can achieve either one or the other, but not both at the same time.”-Friedrich Hayek, Austrian economist, The Road to Serfdom

In addition, as discussed last August 13 to 17, [see US FEDERAL RESERVE Is Financial Markets Sensitive!) since the US economy’s core source of financing for its household consumer spending patterns has been the financial markets, we argued that the FED would do everything (“inflationary”--you can name all sorts of programs or rescue packages) it can to avert a crisis.

Another very important aspect which we would like to add in the considering the present predicament is the construct of today’s de facto monetary standard, the US dollar standard.

Such essentially operates under the FRACTIONAL BANKING RESERVE principle as defined by wikipedia.org, ``refers to the common banking practice of issuing more money than the bank holds as reserves. Banks in modern economies typically loan their customers many times the sum of the cash reserves that they hold.”

When we deposit 100,000 pesos to a bank, our expectation is that our deposits will be safeguarded and the bank will pay us 100,000 pesos when we demand it. The unfortunate part is that under the fractional reserve banking standard, on an aggregate basis, “reserves” reflect only a fraction of our accrued deposits, (to our example such bank has only 10,000 pesos!).

The fractional banking principle is actually a “cartelization” of banking industry. The distinguished Murray Rothbard of the Austrian School of Economics in a 1995 describes the present money standard (highlight mine),

``In modern central banking, the Central Bank is granted the monopoly of the issue of bank notes (originally written or printed warehouse receipts as opposed to the intangible receipts of bank deposits), which are now identical to the government's paper money and therefore the monetary "standard" in the country…

``Here's how the counterfeiting process works in today's world. Let's say that the Federal Reserve, as usual, decides that it wants to expand (i.e., inflate) the money supply. The Federal Reserve decides to go into the market (called the "open market") and purchase an asset. It doesn't really matter what asset it buys; the important point is that it writes out a check. The Fed could, if it wanted to, buy any asset it wished, including corporate stocks, buildings, or foreign currency. In practice, it almost always buys U.S. government securities…

``Thus, the Federal Reserve and other central banking systems act as giant government creators and enforcers of a banking cartel; the Fed bails out banks in trouble, and it centralizes and coordinates the banking system so that all the banks, whether the Chase Manhattan, or the Rothbard or Rockwell banks, can inflate together. Under free banking, one bank expanding beyond its fellows was in danger of imminent bankruptcy. Now, under the Fed, all banks can expand together and proportionately.”

Two things to bear mind:

One, today’s highly leveraged non-banking finance (hedge funds, security dealers insurance and pension funds, credit derivative companies, et. al.) reflects on the basic principles of the FRACTIONAL RESERVE Banking standard but have been unsupported by a cartel of Central banks (once again as my premise last week…government policies reflects on the markets and not the other way around) and…

Second and most importantly, as Murray Rothbard asserted, the banking industry as an indispensable conduit of the fiat monetary standard cartel, authorities will ALWAYS contrive actions to bailout the system REGARDLESS of the costs. Abandoning the banking cartel is almost equivalent to a rescindment of today’s fiat money standard. Such is unlikely to happen.

This has been echoed by mainstream economists such as Harvard’s Martin Feldman who on Friday warned of a growing risk of US recession and recommended immediate rate cuts, quoting a report from Bloomberg, ``Lowering interest rates may result in a ``stronger economy with higher inflation than the Fed desires,'' a situation that Feldstein described as the ``lesser of two evils.''

FED RATE CUTS: USE History as a Guide, Not Gospel

``Every crackup is the same, yet every one is different. Today’s troubles are unusual not because the losses have been felt so far from the corner of Broad and Wall, or because our lenders are unprecedentedly reckless. The panics of the second half of the 19th century were trans-Atlantic affairs, while the debt abuses of the 1920s anticipated the most dubious lending practices of 2006. Our crisis will go down in history for different reasons.”-James Grant-The FED’s Subprime Solution

We’d like reiterate our view where policy actions such as rate cuts are no guarantee to the resolution of the imbalances in the US economy, much more to expect the same in the financial markets.

In the words of Standard & Poors’ Chief Strategist Sam Stovall (highlight mine), ``Our advice this time around is, as always: use history as a guide, but not gospel. The rate reduction, in our view, relieved the tension surrounding the credit crisis, but it has not removed the underlying concern surrounding the economy and the stock market.” (The S&P group expects the S&P 500 to end the year at 1510 or 2.44% up than Friday’s)

As a concrete example, the recent series of action like the provision of contingent liquidity, lowering of discount rates and the temporary exemption in the financing of brokers-dealers have not relieved the markets of the present stresses YET.

This from Mish Shedlock (highlight mine), ``There have been some 300+ government initiatives to make housing more affordable and every one of them failed including Fannie Mae and Freddie Mac. The reason they failed is because by promoting housing with tax breaks, cheap loans, the ownership society, etc etc home prices are bound to rise. And rise they did until a blowoff top was reached which is exactly where we are now."

One must be reminded that the recent monetary policies initiated by Mr. Greenspan to prevent deflationary depression have been a structural contributor to the recent credit bubble, whose pain we are today experiencing. Put differently, the temporary efforts to boost economic activities through diverse government policies or interventionism results to the boom bust cycle. These may not happen all at once, but as the Austrians assert, they eventually set in.

Further we’d like to add that aside from finding its roots in the attempt to maneuver and manipulate the markets to meet their desired ends; like clockwork authorities validate our observation that they are REACTIVE in nature to the envisaged problems and employ treatment-based political appeasement measures.

The growing clamor for rate cuts has evidently seen political pressures militate on the authorities, where the need to take action has prompted the Bush-Bernanke tandem to go public with matching rhetoric.

I’d like to quote Nassim Nicolas Taleb anew, ``Everybody knows that you need more prevention than treatment, but few reward acts of prevention. We glorify those who left their names in history books at the expense of those contributors about whom our books are silent. We are not just a superficial race (this may be curable to some extent); we are a very unfair one."

So if one is to expect collective government’s knee jerk measures to resolve on the present fixes, the odds looks likely against it.

But of course, we can’t shut our doors to miracles.

Credit Card Strains and the Austrian Trade Cycle

``The ultimate cause, therefore, of the phenomenon of wave after wave of economic ups and downs is ideological in character. The cycles will not disappear so long as people believe that the rate of interest may be reduced, not through the accumulation of capital, but by banking policy. Ludwig Von Mises On the Manipulation of Money and Credit, p. 139

Figure 2: stockcharts.com: Credit Card Next? Slowing Retail and Financials

We have to admit the recent rebound in the equity markets appear to have lifted the S & P retail index away from its downward path (see topmost panel) as shown in Figure 2. However, it is too soon to say with confidence that the storm has passed.

Meanwhile, the financial index, found at lower pane below the retail index, responsible for 20% of the S&P 500 industry weighting and close to two-fifths of the profits still undergoing the angst from the recent liquidity crunch.

Aside from mortgages, one of the financial channels which US consumers access to support their spending patterns is through credit cards.

This from the Financial Times, ``Credit card companies were forced to write off 4.58 per cent of payments as uncollectable in the first half of 2007, almost 30 per cent higher year-on-year. Late payments also rose, and the quarterly payment rate - a measure of cardholders' willingness and ability to repay their debt - fell for the first time in more than four years.”

Let us not forget that as part of the income flow securitization, where three general features (wikipedia.org) are found—pooling and transferring of receivables, structuring and issuing securities, servicing, allocating payments and monitoring, credit cards constitute an important part of such asset backed securities, usually either as Master Trust or Issuance Trust.

And further deterioration in credit card payment schedules or actualized losses could likely to lead to subprime mortgages-like losses in several financially engineered products. The illiquidity contagion phenomenon is indeed spreading.

In figure 2, both Master Card (main window) and American Express (lower window) have similarly reflected infirmities in share prices. Are they today, telling us of the state of US consumers?

With strains over at the credit markets, the burden grows for the credit market represented by Credit Rating Agencies.

Established rating agency Moody’s President Mr. Brian Clarkson sees an unprecendented bout of illiquidity where in an interview with Reuters (covered by Bloomberg) he says, ``I've been in the marketplace for 20 years ... what we're experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before," Clarkson told Reuters in an interview. "A lot of it has to do with transparency: it's not clear who owns what."

As we have pointed out in the past, symptoms of transparency, illiquidity, common holder factor problems, crisis of confidence and others are simply reflective of the business cycle underpinned by the credit cycle. The great Ludwig von Mises, describes of the Austrian Theory of the Trade cycle in 1943, which appears to set the tone in today’s economic and financial landscape (highlight mine),

``Once the reversal of the trade cycle sets in following the change in banking policy, it becomes very difficult to obtain loans because of the general restriction of credit. The rate of interest consequently rises very rapidly as a result of a sudden panic. Presently, it will fall again. It is a wellknown phenomenon, indeed, that in a period of depressions a very low rate of interest-considered from the arithmetical point of view-does not succeed in stimulating economic activity. The cash reserves of individuals and of banks grow, liquid funds accumulate, yet the depression continues…

``It has often been suggested to "stimulate" economic activity and to "prime the pump" by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.”

``Finally, it will be necessary to understand that the attempts to artificially lower the rate of interest which arises on the market, through an expansion of credit, can only produce temporary results, and that the initial recovery will be followed by a deeper decline which will manifest itself as a complete stagnation of commercial and industrial activity. The economy will not be able to develop harmoniously and smoothly unless all artificial measures that interfere with the level of prices, wages, and interest rates, as determined by the free play of economic forces, are renounced once and for all.”

Are the Austrians right and we could be facing the inevitable turn of the trade cycle?

How to Prudently Play the Market

``Safety is something that happens between your ears, not something you hold in your hands."- Jeff Cooper, Celebrity (1920-2006)

So how does one today face to the markets?

First we are in deep uncertainty (Knightean uncertainty or incalculable outcome) whether the actions taken by policymakers will have substantial remedial effects to the US markets and the economy or not, a very important driver of global markets today. My bias is towards the latter given my predilections for the Austrian’s perspective.

The markets could continue to rebound in the coming sessions but fall hard if measures taken will be insufficient to mitigate the present circumstances. So a dose of caution is warranted.

Second, to assess on Standard & Poors’ Sam Stovall’s projection (for a yearend target of the S & P 500 at 1510 or 2.44% from Friday’s close) appears inclined towards unfavorable conditions for investing today since markets appear to have interim greater downside than upside prospects (again using the US benchmark as bellwether to global equities and in the assumption that US and global equities would continue to move congruently).

Next, the Economist laid out its cards for a probability scenario where it says that 60% is likely to be odds where the credit crisis would be resolved in a gradual and orderly manner. It weighted 30% for the US to enter a recession while 10% for the world to enter into a “severe economic repercussions…with devastating effect”…a.k.a. depression.

So let us put it in a table and weigh the asymmetric odds and outcomes…

Here we purposely omitted the depression scenario as not to skew the bias towards the pessimists.

Gains are likely to be favorable if we look on this equation from the frequency standpoint.

However, how much is made or the magnitude of the gain or loss is what matters to us, investors.

As such we see that in the above table, the risks side is likely to significantly outweigh the benefits. Or if the risk scenario materializes, it would costs us more in terms of losses (in Pesos) even if it has lesser chances of happening.

So under such conditions a defensive stance would be most judicious, either by raising a significant cash position relative to overall portfolio or to undertake short term “small” or “position-sized” trades backed with stop loss measures (for those with irresistible temptations to tinker with the market).

Now for those who can afford the volatility may close their eyes and stay long because we believe the Phisix should recover and move advance over the long term.

Phisix: Local Investors Take On the Driver’s Wheel; Fed Actions Should Be Bullish Long Term

``The strength of your character comes not from how you react to your successes, of which I know there will be many. The strength of your character comes from how you react to your failures, of which there also will be many, especially if you make bold moves. So, always believe in yourself, persevere, but be willing to adapt.”-Larry Bock, Lux Capital

Now we understand that the Phisix has rallied vigorously from its lows to perk up the hopes of the bulls.

Figure 3: PSE: Peso Volume: Declining Volume

Yet we remain unconvinced since technically the rally has been accompanied by diminishing volume (green trend arrow- red arrows marks the tops) as shown in Figure 3. Such rallies are likely characteristics of relief or clearing rallies coming off from a significant selloff but are unlikely harbingers of interim good news.

Figure 4: PSE: Local Investors: Declining volume but Market drivers

Nonetheless, not everything we see is bad. One thing which surprised us much was the way local investors have been able to engineer a massive rally in the face of foreign selling.

While we have seen intermittent activities led by local investors in the past, the recent streak of gains coupled with its attendant intensity was even more remarkable.

Local investors in the past have been seen driving second and third tier issues, but from the lows of August 17^th, local investors were able to push both index issues and the broader market to garner a 15% gains for two weeks! A first in the present cycle, amazing!

Figure 5: stockcharts.com: Emergent signs of divergences?

Further we saw some seminal signs of DIVERGENCES last week, see figure 5, where the US markets fell hard but the Phisix fell below in degree relative to the US markets (used to be that Phisix would move about 2-3x the performance of the US markets or “Beta”). While the US markets fell Thursday, instead the Phisix moved higher!

This shows how local investors have gradually imbued of the significance of the markets, which in my view is part and parcel for any unfolding bullish cycle.

Anyway we have been long term bulls over the prospects of the Philippine financial markets. And given that a depression is less likely a scenario to unfold, the future actions by the US Federal Reserve will benefit the local markets by establishing a complete divergence or possible decoupling. The flood of money unleashed by the Fed should likely boost the “strong links” in the global financial markets, which this time should be…Asia!

One of our favorite analyst Mr. Louis Gave of Gavekal Research deals with such an outlook (highlight mine)…

``During the Asian crisis, the nadir of the markets involved a number of policy-related events - the Hong Kong government's intervention in its domestic equity market, the bailout of LTCM by a Fed-organized consortium, central bank rate cuts, etc. The central banks took their time in acting (the Asian Crisis started in July 1997, and the rescue did not come until October 1998), since the balance sheets of the Western World's banks did not look threatened. However, once bank shares started collapsing, central banks were quick to act…

`` After the Asian crisis, the extra liquidity injected into the system went into the technology sector, and then into housing (which, at the time, offered strong fundamentals). In the late 1990s, these were the "strong links" in the global financial system. Ironically, 10 years to the day after the Asian crisis, Asia has now become the strong link in the global system. To put it another way, money in Asia to this day is still cheap and plentiful. Following the Fed rate cuts and liquidity injections, money will be even cheaper and even more plentiful. As we see it, this can only have a positive impact on asset prices around the region…

`` The Western central banks' cuts in interest rates and injections of liquidity will force Asian policymakers to make a choice. Will they:

`` Allow their currencies to appreciate against Western World currencies? If this happens, it will mark the final unraveling of the effects of the Asian Crisis, and Asian countries should see the same kind of consumption boom which the Western World experienced between 1997 and 2007.

`` Continue to maintain their currencies at an artificially low level against Western World currencies? To do this, Asian policymakers will have little choice but to print massive amounts of money and run the risk of domestic inflation.

``Either way, it seems to us that investors in Asian assets are today sitting in a very comfortable position. Either, we will see massive currency appreciation and a boom in domestic consumption, or we will witness large liquidity injections which almost ipso facto guarantee a sharp rise in asset prices.”

Short term uncertainty. But long term gains. The Phisix 10,000 in the horizon!

‘Scapegoating’ the Markets?

It’s finger pointing time again! In every crisis there’s got to be a scapegoat, and with the ongoing tremors felt in the global financial markets, the easiest blame always falls to where the stress is evident—the markets.

First, financial markets become the OBJECT OF SCORN for transmitting adversarial conditions to the real economy or to our ‘hapless’ neighborhood folks. Second, markets are DOWNPLAYED FOR THEIR CONTRIBUTIONS to the economy and worst of all, markets are even portrayed as AN ECONOMIC WEDGE to the society’s income class structure!

But do markets really deserve such blame or are these symptoms to other UNSEEN factors glossed over by such commentaries?

The investing public talk today about the US subprime blowout as is if it was a staple; your every morning oatmeal or ‘pandesal’ and coffee on your breakfast table. The notion is that the subprime woes CAUSES today’s market jitters.

In contrast, for us, the subprime imbroglio is only a strain to a deeper structural malaise bluntly dismissed by the mainstream.

Subprime loans are simply loans to people who are less financially qualified or have spotty credit histories. In the US, these imploding subprime papers represent the popping bubble in its housing industry that preceded it. Such instruments were mostly used in the acquisition of assets by the public in the belief that:

1.) monetary conditions would perpetually remain favorable or interest rates would remain always low or

2.) housing prices would continually rise which encouraged speculative “flipping” purchases, which became a vicious cycle even by those who can ill afford to make those regular mortgage payments or

3.) access to these loans to refinance or extract from existing equity to fund lavish lifestyles are immune from economic cycles

In sum, subprime loans were acquired NOT for productive purposes, but either for plain consumption or outright speculation.

Moreover, originators and other lending intermediaries took advantage of the sizzling hot love affair with the Housing boom and engaged the public’s appetite with more adventurous risk taking behavior through a reduction of lending standards.

Nonetheless, this expansive lust for risky assets essentially spread from lenders to investment banks and prime dealers, which packaged and repackaged such securities into highly complex levered forms of instruments, had them stamped with approval by established credit rating agencies and sold to financial institutions (hedge funds, insurances, pension funds, corporate treasuries etc…) around the world, who were then hungry for profits or to those who were eager to match returns with existing liabilities, in a world where rates of returns have diminished.

In short, in boom times risk was conventionally thought to have been “EXTINCT”.