Phisix: A Tug of War Between the US Dollar and US Markets Determines Outcome

``And of course, one of the new rationales to justify the dollar trend of late is this canard: A tumbling dollar is “really very good” for the US economy. Yeah, sure it is! Can you imagine how much better off the average US citizen would be if the dollar fell to something like 40 on the US dollar index? Heck, in a world where Mr. US Consumer imports more goods than he ever did in the past, imagine if his global purchasing power was cut in half. That would be just dandy wouldn’t it! Where do they come up with this nonsense?” - Jack Crooks, Black Swan Capital

While Glorietta 2 will take our markets down for over the short-term, one potential variable with far greater risk influence is the recent turn of events in the US markets.

As the investing public widely knows, July’s market downturn had been an offshoot to the recent seizure in the global credit system that has led to a bout of liquidity driven selling prompted by the commonly touted “subprime” losses.

Following the coordinated efforts by global central banks to restore or normalize the liquidity flows in the global financial system, the markets have shown strong signs of recovery to the point that many global equity indices have succeeded to surpass previous highs. This astounding pace of rebound has somewhat restored confidence into the marketplace.

Yet, regardless of the stream of successes in the equities front, we pointed out how the global credit markets have failed to completely normalize which posed as the proverbial “Damocles sword” over the recent bacchanalia.

The justification from which has lent the global markets a considerable upside momentum had been

1.) the expectations that the vigorous global economy would continue to cushion the US economy from a hard landing as evidenced by the robust performances of industries with substantial exposure to the global economy, and

2.) the “don’t fight the FED” arguments or that investors would continually be shielded from steep losses by the “Bernanke PUT” or the tendency of the US Federal Reserve to keep injecting liquidity into the system to buoy the financial markets and keep the Main Street from falling into a recession.

Such positive spin has concomitantly been reflected in the performance of the US dollar index which has evinced of continued infirmities (drifting in uncharted lows) in the face of potential inflationary actions by the US FED.

US Dollar Woes: Exodus of Foreign Investors in August

Yet, the somber part shows that where US had been heavily dependent on foreign central banks as a backstop to bridge the capital flow gaps from its current account deficits, the recent turmoil has prompted these stopgap actors to visibly reduce their holdings on US dollar assets. The US requires around $70 billion dollars a month or about 25% to 30% of portfolio money to fund commercial papers market during the last two years.

According to the US Treasury International Capital flow for August the US recorded a negative $69.3 billion capital flow where both foreign public institutions and private investors shied away from supporting US denominated assets as shown in figure 2. Leading the pack of the exodus included major Asian trade partners as Japan and China.

Figure 2: Yardeni.com: Net Security Purchases By Foreigners Turns Negative!

This from the Ambrose Evans-Pritchard of the Telegraph (highlight mine), ``Asian investors dumped $52bn worth of US Treasury bonds alone, led by Japan ($23bn), China ($14.2bn) and Taiwan ($5bn). It is the first time since 1998 that foreigners have, on balance, sold Treasuries….

``Central banks in Singapore, Korea, Taiwan, and Vietnam have all begun to cut purchases of US bonds, or signalled an intent to do so. In effect, they are giving up trying to hold down their currencies because the policy is starting to set off inflation.”

So, from an orderly adjustment comes the heightening risk where the US dollar could unwind violently.

Black Monday’s 20^th Anniversary: A Sympathy Decline?

Friday, October 19^th was the 20^th anniversary of the fateful Black Monday Crash, the worst ever one-day decline experienced by the US markets which resonated around world, where the Dow Jones Industrials tumbled by 22.6% in 1987!

The anniversary appears to have undesirably been met with a “sympathy” decline in the US markets where the Dow Industrials fell steeply by 366.94 points or 2.64%, S & P 500 39.45 points or 2.56%, and the Nasdaq 74.15 points or 74.15%.

The aggregate losses over a weekly scale were remarkably broadbased which can be seen in Figure 3.

Figure 3: S & P: Week on Week performance by Sector

While figure 2 tells us that most of the damages were associated with the industries DIRECTLY linked to the US housing recession and sectors affected by slackening domestic consumption, which has been as expected, we are alarmed by the steep falls in the previously globally levered sectors as the information technology and the energy sectors and the consumer staples with overseas revenue exposures of 56%, 56% and 47% respectively (revenue weightings according to the Sam Stovall of the S & P).

Week on week the financials continue to bleed heavily down 7.62%, followed by consumer discretionary, Utilities, Materials and Industrials with losses of over 3%.

Could it be that foreign selling in the US securities has PRESENTLY spilled over to equities as part of the diversification out of US dollars?

Figure 4: Yardeni.com: Foreign buying of US Equities still positive but dropping steeply!

Foreign support for US equities has mostly emanated from Europe and the Rest of the World, where Asia had been a marginal net buyer since the start of the year.

However, the sharp drops in the degree of buying in August comes mainly from Europe and the ROW and has steeply dragged down the overall 12-month sum and the 3 month annual rate as shown in Figure 4 courtesy of Dr. Ed Yardeni’s Yardeni.com.

In others words, given that the US dollar trade weighted index is now trading at its ALL time lows as shown in figure 5, there is that big chance where the outflows which began in August could be a START of a new trend and not merely an aberration.

A Tug of War Between the US Dollar and US Markets

Figure 5: Netdania.com. US dollar index at All time Low

Where in contrast to the precipitate drop last July which had been spurred by liquidity woes as corollary to a sudden systemic credit drought, the recent losses suffered by the US markets had been imputed to corporation earnings deterioration apparently reflecting the worsening state of the US economy.

The distinction is that THEN Global central banks were quick to respond to the credit seizure with an admixture of policy adjustments to provide for band-aid treatments which apparently succeeded, as measured by the performance of the equity markets.

Today the problem seems different, while the credit woes implied monetary tightening; the aftereffect could now be seen in surfacing in corporate earnings as shown by the S & P chart in Figure 6.

Figure 6: Stockcharts.com: S&P, Phisix, Gold and US 10 year Treasuries

The sharp decline in S & P 500 has been accompanied by a considerable volume buildup as shown by the blue circle in the main window. This could suggest for further downside action.

Recently we have pointed out that the Philippine Phisix (above window) has been increasingly correlated with the movements of the US dollar index than to the US markets since the recovery run last August. However, it should be noted too that the former’s connection with the US markets remains significant as shown by the blue vertical lines where volatilities or inflection points have been almost in lockstep.

This has also been mostly true with gold…until February. But apparently, the latest activities in gold prices have considerably shown a MARKED DIVERGENCE; it was least affected during the July credit squeeze and has grown strongly despite the recent weakening in the US equity markets (green circle).

Nonetheless, the collapse of 10 year Treasury yields (red circle in the lowest pane) in the light of probable foreign selling depicts overarching concerns over the vitality of the US economy.

As we have repeatedly said, despite the record high oil and gold prices, Chairman Bernanke and the US Federal Reserve, who realizes of the sensitivity of its financial driven economy to the degree of leverage embedded within its system, aside from protecting the primary conduits of the Fiat Paper Currency standard, will risk to err on the side of inflation, where its monetary policies will adjust depending on the performance of its equity markets in lieu of the accelerating decline in the housing industry.

The US treasury’s plan to convene banks and financial institutions to create “a single master liquidity enhancement conduit, or M-LEC” is simply one of these measures to shelter banks from further losses.

To put bluntly, if the US equity markets continue to drop and hit our 10% strike price (Dow Industrials 12,780 or S&P 1,410), we should expect the FED to cut by another 50 basis points, where the sharper the drop, the bigger or the more frequent those cuts will be.

Otherwise if the US market recovers and continues its upside move then it could defer its action until the market reveals signs of distress.

With Friday’s move, we can expect the market to test the downside.

Across the Pacific, at the current clip we expect the Phisix and Asia to trail the US markets until those gamut of rate cuts would shear the “umbilical cord” that joins the US and the Asia.

In other words, volatilities prompted NOT by Glorietta 2 but by the actions in the US dollar and the US markets are likely to sway the Phisix over the interim.

But, we expect buoyant gold and oil prices to support or cushion emerging markets as well as the “strongest link” embodied in the Asian region.

In effect, we should expect to see the deepening of such divergences as the foreign central banks and private institutions reallocate more of their funds away from US dollar assets, where the incentives to own and support these appear to have greatly waned by:

1. Rising Asian and OPEC inflation rates which could lead to the depegging of currency links (Gulf countries) or should translate to further domestic currency appreciation requiring less to recycle surplus funds into US dollar denominated assets.

2. Losses could prompt Central Banks to cut positions as the declining US dollar reinforces the loss in the price values of their portfolios.

3. The prospects of an economic wide spillover from the accelerating deterioration in the US housing industry should translate to declining returns or yields.

4. A rapidly slowing US economic outlook would prompt for expectations on policy actions that would narrow the currency yield spreads and reduce the advantages of holding US dollar assets.

5. Through Sovereign Wealth Funds (SWF), global central banks have now been shifting to non-US dollar assets to increase returns via purchases in mostly global equities.

Even the IMF recently says that the US dollar remains overvalued.

The US dollar may bounce due to being technically oversold. But if the August trends reveals of a sustained outflow from its foreign principals then the US dollar will likely head lower and should mark an all important inflection point. And asset allocations would ultimately adjust to such developments.

Global Markets: High From Wall Street And FED Steroids?

``The capitalistic social order, therefore, is an economic democracy in the strictest sense of the word. In the last analysis, all decisions are dependent on the will of the people as consumers. Thus, whenever there is a conflict between the consumers views and those of the business managers, market pressures assure that the views of the consumers win out eventually.”-Ludwig von Mises, On the Manipulation of Money and Credit

Global markets remain on fire last week with many bourses posting new highs.

In Asia alone, while the gains of the Philippine Phisix had been modest (+1.28% w-o-w for the FOURTH successive week), impressive gains were seen in China’s Shanghai Index (+6.32%, w-o-w), Indonesia’s JKSE (+5.5%), Bangladesh’s Dhaka Index (+4.88%), Thailand’s SET (+4.07%), India’s BSE 30 (+3.63$) and Hong Kong’s Hang Seng (+3.62%). Only Taiwan’s Taiex (-1.26%) and China’s Shenzhen Index (-.98%) were down for the week.

Figure 1: stockcharts.com: ASEAN Bourses On A Streak!

Figure 1 shows of an apparent “choreographed dance” by ASEAN bourses, with Indonesia’s Dow Jones Indonesia in the lead following a strong breakout (pane below main window) to account for a remarkable year to date gain of 46.12% (as of the Oct. 12^th)!

Our Phisix (main window) hovers slightly above its previous resistance (now support) following the latest move to etch a FRESH historic high, which accounted for a year to date advance of 28.22%.

Meanwhile, Thailand’s SETI (middle pane) and Malaysia’s Dow Jones Malaysia (lowest pane) appears be at edge of the same “breakout” routine, with year to date gains of 30.48% and 25.45%, respectively.

Technically speaking, with the Phisix clearly WAY above its 50-day and 200-day moving averages (dma), represented by the superimposed blue and red line, this signifies indications of OVERBOUGHT conditions. Moving averages are the average prices of a security over a defined period, a barometer utilized by trendwatchers to gauge on the health of a trend.

But again since markets don’t move MECHANICALLY, plain momentum and raw emotions can simply prod the Phisix to do an Indonesia and overextend the current trend.

And since markets are behaving in near unison, it does not seem pragmatic to look at the action in the Phisix as a singular metric in determining the ebbs and flows of the present short term trend.

Aside, similar to last week which came COINCIDENTAL to the breakdown of the US dollar trade weighted index, foreign money has turned meaningfully positive but saw a decreased exposure relative to the local counterparts.

What this implies is that aside from the conventional “portfolio” money “IN” flows, we have been witnessing a trend of enhanced participation by local investors.

And amidst the concurrent breakdown in the US dollar is the mirror images-record closes of the Baltic Dry Bulk index (above 10,000- a fresh all time record), Oil via the West Texas Intermediate Crude benchmark (fresh all time record) and gold, which appear to have supported emerging market equities, aside from the “global outperformance” theme which has equally steered US stocks to record highs.

Could it be that the current market activities simply reflects on the recent spike in US monetary aggregates as shown in Figure 2?

Figure 2: St. Louis Federal Reserve: Surging M2 and MZM

According to the St. Louis Federal Reserve, through August, M2 (seen in the left) or a measure of money supply or liquidity as defined by investopedia.com ``money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds” surged by 8.6% per annum, while MZM or Money Zero Maturity (seen in the right) also another measure of liquidity as defined by investopedia.com, ``MZM represents all money in M2 less the time deposits, plus all money market funds…MZM has become one of the preferred measures of money supply because it better represents money readily available within the economy for spending and consumption. This measurement derives its name from its mixture of all the liquid and zero maturity money found within the three "M's.” soared by 24.3% per annum!

Are we thus seeing the effects of the combined reliquifications by Wall Street via money market funds or mutual funds that strictly invest in short-term but low risk liquid instruments as US government agencies and treasuries, and the US Federal Reserve?

Phisix and the Peso: CORRELATION DOES NOT IMPLY CAUSATION

``Predicting a circumstance can sometimes help prevent its occurrence—if it’s controllable. And most dramatic changes in life, markets and science often occur from circumstances that couldn’t be predicted. And even if they could be predicted, they might not be controllable (earthquakes, torrential downpours). But that doesn’t stop the circumstances’ actors, 24-hour cable pundits or policy makers from explaining pretty much everything away. This is natural, part of our biology. We seek causation. We seek confirming evidence.”-Joshe Wolfe Forbes Nanotech

Figure 3: Economagic: Strong Currencies back ASEAN Equities

Again the strength of the Peso has mirrored the Phisix, with both drifting at breakout territories. The same story can be seen applied to our ASEAN neighbors, as shown in Figure 3.

In contrast to the mainstream thinking that the Peso’s rise has been endemically propelled, Malaysia’s recently unpegged Ringgit and the politically hampered Thai Baht has shown similar relative strength that appears to have equally bolstered their bourses.

In the latest blog post last Wednesday, following a record run by the Peso, we were delighted to see a more germane reportage from which we quote anew the Philippine Daily Inquirer (emphasis mine),

``Traders said offshore investors were more bullish than local traders and were quoting the peso at 44.15-44.20 to the greenback in over-the-counter deals, outside the currency exchange Philippine Dealing System.

``The peso would have strengthened further if not for continued dollar-buying by the central bank, Bangko Sentral ng Pilipinas (BSP), on the spot market. However, dealers said the BSP purchases were not as heavy as in previous days as its dealers saw that the market was nearing a correction.

``The BSP purchases were estimated at $100-$200 million. Tuesday’s total volume was $640 million.

``The peso’s extended rally was also supported by a strong regional currency market, which in turn was caused by weak sentiment on the US dollar and by the region’s much-improved economic fundamentals.

Bullish Foreigners, Regional Driven, and State of Today’s Money System

Three notable observations:

One. Foreign investors have shown more BULLISHNESS in the currency market than local investors of late.

This similarly reflects on the internal activities of the Phisix since the advent of October, as noted above.

Two. The Peso’s moves are reflected REGIONALLY and NOT AN INSULATED phenomenon.

This is where it can be shown that the arguments of the baneful effects of a strong Peso signify ONE dimensional thinking.

Since the region’s currencies have been on an equally firming trend but on a distinct degree, the competitiveness of our industries depends on country’s scale of productivity and efficiency and not simply brought about by pricing power or through currency mechanisms.

Blaming the Peso for our woes is tantamount to barking at the wrong tree. Instead, experts should look at the economic or opportunity costs of politicization of the industries, overregulation and skewed policies, as well as, choking bureaucracy and the endemic culture of dependence (mostly to politicians) and risk taking aversion.

The growing obsolescence of the “Mercantilist” paradigms, aside from contributing more to global imbalances, and knee jerk reactions such as suggestion for capital flow restrictions or currency manipulation will improve LESS of the Philippine’s economic conditions. These signify temporary stop-gap measures which don’t deal with structural deficiencies of the economy. The present economic models should take advantage of the deepening trends of technology enabled regionalization as well as niche marketing/specialization in this much integrated world.

Three. The strength of the Peso and of the region reflects the state of the today’s Fiat Currency standard.

Essentially, it is NOT the Peso which is rising but of a phenomenon of a depreciating US dollar, the world’s de facto foreign currency reserve. The fall of the US dollar against a majority of world currencies simply reflects on the ACCRUED EFFECTS of misdirected policies in the US. Since the US dollar functions as the anchor of today’s monetary structure, naturally its conditions RIPPLE throughout the financial and economic realm worldwide.

So under present conditions, either our central bank or the BSP allows of an unfettered market determined rise of our currency, which should give rise to a consumption boom and/or trigger a massive reverse capital flight or repatriation of domestic capital stashed overseas (think Filipino migrants buying domestic real estate or investing in call centers or investing into the Phisix), or applies a “managed” float via open market interventions or printing pesos to buy US dollars, which adds to domestic liquidity.

The news report manifests of the second option. Nonetheless, in both instances, conditions allow investors the “incentive” to further rev up on the Phisix over the long term.

Political or Economic Democracy?

Let us divert for a while and dabble on the political context of this issue; as we have repeatedly argued, such inflationary actions (such as currency intervention) add to social inequality. While it stands to benefit select industries as ours, the promulgated intent, as advocated by some mainstream experts, of attaining an egalitarian society or social equality using inflationary activities like the above is almost equivalent to the idiom “left hand doesn’t know what the right hand is doing”. The end effect has always been through diminishing business competitiveness, surge in taxes and rising consumer prices.

One has to understand that the major beneficiaries of government inflationary activities are the banking and finance industries, the main conduits of the Fractional Banking Reserve system, and most importantly the political bureaucracy and their associate providers or “special interest groups” (e.g. the alleged doleouts to select local government units and members of the congress by the present Philippine incumbent administration) where they are accorded the privilege of buying freshly printed money with today’s prices while leaving out the public to buy at tomorrow’s much higher prices-mostly in the name of social equity but behind the scenes is all about the perpetuation of power.

Most politicians, regardless of their affiliations, are inclined to idealistic vote generating rhetoric but are disinclined to do corresponding unpopular actions of sound money and policies when in power. And so goes with the majority of media, where controversies and short-term nostrum sells.

Yet most of the leaderships within the bureaucracy are predisposed towards reaction “knee jerk” based solutions. Recent reactions of global Central banks exemplify this. While the recent credit crisis appears to have seemingly abated, the day of reckoning has simply been postponed but should worsen in scale. This will likewise be reflected in the financial markets.

On the other hand, prevalent in the street, in the café or again in media, it appears that everybody else knows how to spend on other people’s money in one form of social program or another, without looking at its unintended consequences. Just watch political discussion programs or editorials, everybody seems to be an expert in forecasting. The irony, is when you put them into the markets to apply their “expertise”, none of them can call it consistently right, if they even can make a majority of accurate calls. So how can a political social improver, who is unable to predict the markets rightly, make a right judgmental call on the adequate balances of a living and dynamic economy with even more variables to reckon with? In the case of the US Federal Reserves, former Chair Greenspan escaped without much blemish, but will it apply to Chairman Bernanke as well?

For others, the role of our political economy has been to redistribute wealth from productive individuals or entities to those devoid of the virtues of savings, hard work, and industry or to political parasites. As they say there are two ways to generate wealth by hard work and savings or by plunder. Unfortunately some suggestions cater to the latter though indirectly.

As we always aver, when economic opportunities are determined by politicians and the bureaucracy instead of the markets, our political economy is then reduced to a game of musical chairs, where the vicious cycle of personality based politics signifies only a symptom of a deeper structural malaise; the lack of respect for a market driven economy. We opt to choose our leaders via political democracy but elect to have our economic choice determined, not by ourselves, but by political leaders, whose operating incentives are far different than ours.

Some Asian nations have shown, like the Hong Kong and Singapore, how the lack political democracy can be compensated by a market based economy or economic democracy or the respect for entrepreneurs. However, some see it the other way around, obliquely the success of political control, you call this selective perception. Unfortunately for us, we see what we want to see and choose not to learn.

Correlation Does Not Imply Causation

Now back to the financial markets, the perspective that the strength of Peso is required to bolster the Phisix has been tangential as shown in Figure 4.

Figure 4: Phisix-US Dollar Peso: Correlation Does Not Imply Causation

While the Phisix (black candle) and the Peso (red line) have shown stronger correlation of late, one must realize that the Phisix had been on an uptrend since June of 2003 (thanks to Greenspan’s 1%! Fed Rate), as shown by the upside green arrow, even when the Peso continued to flounder. The Peso only reversed in October of 2005, shown by the downward pointing blue arrow, almost ONE full year when we made our forecast and TWO YEARS AFTER the Phisix gradated into the advance cycle.

And in perspective of the past advance cycle in 1986-1997, the Phisix had not been accompanied by an attendant rise of the Peso. Yet, past conditions are unique to the present, unworthy of simplified association.

In short, as we always argue, CORRELATION DOES NOT IMPLY CAUSATION. Although, they may have interlocking relationship somewhere, it COULD NOT BE ESTABLISHED as a textbook case of “cause-and-effect” over the bigger picture. Such attribution requires more evidences of sustained tight correlation over time.

Yet, this similar frame of oversimplified narratives (using different variables) on the Peso’s conditions can be found elsewhere in the mainstream analysis or media reporting, something we will deal with sometime in the future.

The Media Indicator and Reaping What You Sow

``What defines sucker money is not the horse selected, but the acceptance of odds on that horse that are substantially out of line with its chances of winning… even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing; the odds. A horse player cannot remind himself of this simple truth too often, and it can be reduced to the following equation: Value = Probability x Price.” Steven Crist, veteran horse bettor and publisher of the Daily Racing Forum

Nonetheless, financial markets usually reflect a social phenomenon, where people tend to assimilate the action of the others based on the perception of success.

The concatenation of advances (fourth straight weekly advance up 16%) in the Phisix has set tone anew for media to conjure up articles on how perceptibly easy investing in Phisix has been, so much so that professionals and neophytes can coolly squeeze out gains from the market without the adequate assessment of risks.

While it has been a crusade for us to help inform readers and the public of the merits of financial markets investing, never have we suggested that the markets function as some sort of milking cow. Success from investing comes with rigorous discipline, enduring patience, the ability to assess risks relative returns and developing and practicing Emotional Intelligence, hence, our predilection for Behavioral Finance/Economics. To paraphrase Galatians 6:7 ``You reap what you sow.”

However, portrayals like this, which illuminates on fast riches, gives out false hopes and encourages wanton risk taking appetite, eventually delivers a lethal blow to the emotionally driven media inspired gullible speculator or punter. When the markets become object of arrant speculation, the usual outcome reflects on the manner of which the markets have been treated. Just ask those who got burned in 1997. People get what they deserve. It is just fortunate enough that the cycle still works in favor for the punters.

Further, as we have previously written, this usually serves as precursor of a nearing peak in the cycle. In the US it is called the “Magazine Cover Indicator”, where a climaxing deeply entrenched trend is showcased by media as front page treatment or as major feature (hence the cover) which eventually turns out to be an inflection point. The reason for this is about economic incentives and overconfidence, wrote author Nicholas Vardy (emphasis mine),

``Journalists aren't writing cover stories to make investors money. They are writing cover stories to sell magazines. And "hot topics" sell. But it also means that when a company or financial trend is featured on a magazine cover, the chances are that the trend is already widely known, and universally accepted.”

Selling what the public wants to hear is also about OVERCONFIDENCE, or (wikipedia.org) ``the human tendency to be more confident in one's behaviours, attributes and physical characteristics than one ought to be”, or when applied to the markets the ingrained fallacious notion that the prevailing trend is a permanent feature. Since it is easier to sell what people want to hear or illustratively the confirmation bias, then the tendency is to go and assume greater risk taking activities in the assumption of the continuity of such trend.

The last time we saw this related phenomenon, where a TV news documentary profiled the “basura queen” was in June of this year, following the Phisix breakout from the 3,400 to reach a high at 3,800, which we discussed last June 11 to 15^th edition [the Philippine Stock Exchange: The PUBLIC’s MILKING Cow???!!!].

ONE month after, the Phisix joined world markets into a month long carnage emanating from the dislocation in the global credit markets, an event which has somewhat eased but remains a looming threat to the present revelry as shown in Figure 5.

Figure 5: St. Louis Federal Reserve: Three Month Treasuries Remain Under Pressure

While, according to the St. Louis Fed, the 10 year treasury yields have risen, and where market has priced in the Fed Fund Rates at present levels or for a potential pause, 3 month treasuries remain under pressure, with marginal signs of recovery. In short, while equity markets have priced in a recovery, the credit markets have not normalized.

This is NOT to suggest that the depiction of our Magazine/Media Cover Indicator signifies a TOP, although they as well could.

Our point is to take on a broader perspective and weigh the developments in the context of a global dimension.

Remember, as discussed earlier our markets have been significantly correlated with global markets, where variables of influences such as the Phisix-Philippine Peso relative to the US dollar, inflationary activities of global central banks, surging commodities and activities of the equity benchmarks in Asia and emerging markets appear to convey the same message: Resurgent Inflation.

Philippine Stock Exchange: Supported by Global M & A, Secular Trends and Capital Market Developments

``If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue -- relatively, at least -- companies that are out of favor because of unsatisfactory developments of a temporary nature." - Ben Graham (1984-1976), mentor of Warren Buffett

In our January 8 to January 12 edition, [see Unifying Global Stock Markets; Asia Looks Next!] we wrote how global exchanges had been undergoing consolidation trends, and that the deepening financial integration appears to bolster these developments.

Here we concluded, ``Today, the Philippine Stock Exchange, despite its miniscule capitalization and traded volume relative to global standards or its peers, will be an inescapable part of the ongoing global trends to unify financial market exchanges, such that in the future it will a party to any potential alliances, or consolidations by mergers or acquisitions, as well as, take into account the realization of cross-border listings, after progress on regulatory hurdles would have been met and expanding trading facilities to possibly include other asset markets.”

Recently the London Stock Exchange (LSE) has been the object of interest for acquisition where the Qatar Investment Authority (QIA) acquired 20% of the company while United Arab Emirates’s Borse Dubai in a complex deal with the Nasdaq took over the latter’s stake at LSE to hold an accrued 28% in Europe’s oldest stock exchange in return for Nasdaq’s takeover of the Norway’s Nordic OMX, where the Borse Dubai will also own a significant 19.99% stake.

In Asia, Tokyo Stock Exchange (TSE) in an effort to increase alliances and expand operations recently acquired 5% of the listed Singapore Stock Exchange.

There have also been rumors floating that the Chicago Mercantile Exchange (CME) is interested to acquire substantial positions in the Singapore Bourse Operator, as well as other exchanges around the world.

In short, our thesis that the consolidation trends in global stock exchanges will probably deepen has shown more signs of being validated.

What has this got to do with PSE?

We rarely deal with particular issues but since the PSE is the country’s sole service platform facility for the trading of Philippine equities, or a monopoly at that, we view the PSE as the EMBODIMENT of the Phisix. In short, what happens to the Philippine Stock Exchange will influence the trading activities in the Phisix.

Over the past week, the demutualized Philippine Stock Exchange (PSE) surged 22% to close at 1,005 and is up 258% from the start of the year. It also recorded hefty foreign buying.

While it is speculation on our part that the foreign activities today in the PSE could be part of these global consolidation process, we believe that either this is starting to happen or will become an inevitable part of the financial markets evolution.

Of course, the PSE’s rise could also signify the attendant breakout of the Phisix which recently carve out its NEW highs since the PSE came into existence.

In other words, if you share my view that the Phisix’s long term or secular tend will reach at least 10,000 in the next 5 years, then the PSE is a no brainer, since a rising Phisix will command higher volumes, more fees, more IPOs and an expanded business frontier.

Further with present thrust of our country to continually develop our capital markets, major future projects are lined up for the PSE, such as the proposed incorporation of derivatives trading, the present inclusion of several Phisix member companies in the ASEAN ETF traded in Singapore’s Exchange which could pave way for the future trading of Exchange Traded Funds, the recent introduction of the Securities Borrowing and Lending (SBL), and the prospective cross border listing or listing of shares of a foreign publicly listed company in the Philippine exchange.

Where such capital market enhancements provide investors alternative options and instruments to spread and hedge risks and as well as aim for expanded returns, one can expect the sophistication of asset management to attract significantly more investors in our underappreciated capital markets.

Figure 6 and 7 shows of how PSE’s contemporaries have performed over the past 5 years…

Figure 6: Yahoo.com: Bursa Malaysia and HK Stock Exchange

Having been a dull “lack of story” stock, we never expected an outperformance from the exchange issues, which implies PSE is not a stock for everyone, until now…

But so far exchanges have provided investors with magnificent returns as shown by our neighbors the Bursa Malaysia (left) has jumped 2.5 times since its listing in 2005, while Hong Kong Stock Exchange (right) flew by an astounding 40 TIMES since 2001!

Figure 7: Yahoo.com: Singapore Exchange and Australian Stock Exchange

On the other hand, Singapore Stock Exchange (left) has returned about 5.5 times for its investors over the past 5 years, while the Australian Stock Exchange (right) has yielded about 4.4 times for investors over the same period.

To recap, secular advancing trends for the Phisix, capital markets development and the ongoing mergers and consolidation trends in global markets merits that the PSE be a part of one’s long term portfolio.

While this is not to recommendation for a buy today, a thawing from its recent sizzling performance could provide an entry point.

Important Disclosure: The undersigned owns shares of PSE.

BSP intervenes to Limit Peso's rise.

Excerpts from today’s Philippine Daily Inquirer on the Peso’s milestone 7 year high (highlight mine)…

``Upbeat foreign investor sentiment perked up the peso Tuesday to a new seven-year high of 44.23 to the dollar before profit-taking and central bank intervention pulled the rate to a weaker finish of 44.31, currency traders said…

``Traders said offshore investors were more bullish than local traders and were quoting the peso at 44.15-44.20 to the greenback in over-the-counter deals, outside the currency exchange Philippine Dealing System.

``The peso would have strengthened further if not for continued dollar-buying by the central bank, Bangko Sentral ng Pilipinas (BSP), on the spot market. However, dealers said the BSP purchases were not as heavy as in previous days as its dealers saw that the market was nearing a correction.

``The BSP purchases were estimated at $100-$200 million. Tuesday’s total volume was $640 million.

``The peso’s extended rally was also supported by a strong regional currency market, which in turn was caused by weak sentiment on the US dollar and by the region’s much-improved economic fundamentals.

***

AS we previously noted, either the BSP tolerates the increase of the Peso or limit or control the Peso’s price movement by means of market operations; by printing pesos to buy the US dollar, where both actions are inflationary, added liquidity into the financial system should further prop the activities in the PSE.

Another notable: in contrast to the suggestion of some experts that the Peso’s rise has been a local phenomenon, instead, as pointed out in the article, the Peso’s rise has been impelled by REGIONAL MOVEMENTS, aside from the plight of the US dollar which means this has been a global financial markets driven phenomenon rather than just plain vanilla economics.

We have earlier seen locals support the Phisix during the latest credit crunch shakeout. Since the breakdown of the US dollar Index to an uncharted low, foreign money has now turned aggressively bullish on the Philippine assets. This turn of events could fire up an accelerated ascent in the Phisix barring any shocks.

Global Equity Markets: “Credit scare, what credit scare…where?”

``Economics is an evolving social science. About the only thing we know when we forecast is that the forecast is wrong. The idea is to get close to the trend if you can. Applying economics to financial markets is humbling. 35 years as a practitioner has taught me to be certain about nothing.”–David Kotok Cumberland Advisors

With the recent strength of the global equity markets one must be wondering; “Credit scare, what credit scare…where?”

Today’s environment certainly makes one feel that markets can ONLY MOVE UP, and that all downside actions be treated only as “ABERRATIONS” or as buying windows. Such dynamics only inflates on our risk taking appetite, fosters undue complacency and propagates overconfidence, the typical ingredients for most investor losses.

The recent credit scare provided the intrepid investor fabulous short term returns opportunities via a “masterful” bottom-picking prowess, where from the privilege of HINDSIGHT we get to see how the recent shocks turned out to be a buying opportunity instead.

But what if such “scare” evolved into a full-blown crisis? What appears to be “adept market timing” could translate to “catching a falling knife”…from bravado to foolishness. In other words, from a BACKWARD looking process since the events had already been perfected, it is then easy to pass conclusions…but, again what of the future? Will markets continue to rise amidst the present litany of risks?

As we have recently gathered, the average investor usually salivates on, or frequently applies “regrets” to such forfeited opportunities, without realizing that DECISION MAKING during these critical moments reflects economic or opportunity costs—cost of an alternative action that must be forgone in order to pursue a certain action (answers.com).

For instance, the credit drought, for us, signifies a SYSTEMIC risk, the first ever real threat to our secular bullmarket. These entanglements in the global financial system could have galvanized into a crisis from which markets could have fallen even more dramatically. Nevertheless, the concerted actions by global central banks appears to have successfully mitigated the present junctures but as to its sustainability remains to be seen.

Considering that effusive liquidity has been our perceived drivers of today’s financial markets, the reversal of such operative presents outsized risks relative to returns which we had been disinclined to underwrite. Hence, our opportunity cost was the supposed “bottom” portion of our valiant risk taker’s “fabulous” market returns in exchange for the relative safety of our capital.

While unlike depression advocates, we persistently argued that any extraneous shocks would affect the local markets in the same manner as it would affect its regional contemporaries, but whose effects could likely be ephemeral--given that the credit, financial market, monetary and economic structures are ostensibly nuanced compared to the epicenter of such shocks. In short, the degrees of functional leverage from which emerging markets and Asian economies have been exposed to are conspicuously distinct from its counterparts in the Anglo Saxon regions.

For us, forecasting depression by parsing trade, financial and economic linkages from HISTORICAL data or paradigms ignores the ever fluid dynamics of the tech-enabled “globalization” evolution quite evidently seen in the financial, economic, political, cultural and technological spheres. Such justification appears to reflect single dimensional thinking in a highly intricate world. Yet in a world where shocks have been mispriced, we simply wouldn’t discount of such possibilities.

Nonetheless, does the prevailing upbeat outlook in the world equity markets indicate that all is well and that potential shocks should be discounted?

Figure 1: New York Times: Sickly Credit Markets Heal a Little as Leveraged Loans Rebound

New York Times’ Floyd Norris gives us a great picture of the conditions of today’s credit market as shown in Figure 1 in his recent article ``Sickly Credit Markets Heal a Little as Leveraged Loans Rebound.”

Mr. Norris’ apropos opening statement (highlight mine), ``THERE are signs of life in credit markets that appeared to be dying only a few weeks ago. But those signs are limited. Few investors have returned, but in some cases banks have stepped in to replace them.”

While most of the credit markets appear to have shown marginally increasing signs of relative composure, they have been quite far from their normal post-credit crunch stance. In essence, these reflect on the continuing strains of investor anxiety.

The most apparent among the improvements had been on the account of leverage loans, where according to Mr. Norris volumes have risen “high enough to allow deals to get done.” This could be one of the factors which underpin today’s rallying US equity markets.

Another, loans have swelled for banks as financing deals which they guaranteed prior to the recent shock had been forcibly added to their books. On the hand, a record surge (fastest rate since early 1974) in the volume of commercial and industrial bank loans, reflects ``leveraged loans that could not be syndicated to foreign banks or investors, but most of it probably represents new loans that in previous months would have been done through the credit market”, according to Mr. Norris. Simply put, the confluences of the lack of diversification from the investors profile plus a recovering market help boosted these volumes of late.

So essentially, the credit markets have moved out of the Intensive Care Unit (ICU) but are still under strict surveillance from the Financial Authorities, given the seriousness of the conditions and the risks of regression. Yet relative to the performances of the equity markets, it appears that today’s market climate has severely underestimated the risks concerns.

US Federal Reserve: Hitting Four Birds With One Stone?

``The Federal Reserve's role in prophesying the future course of the economy, the plethora of new indicators brought to the table to maintain the illusion of science, the secrecy of their deliberations, the ambiguous quality of their utterances, the ascetic nature of the chairmen, the elaborate protocol, is possibly idempotent with Delphi.” Victor Niederhoffer, well known Hedge Fund Manager

As we have noted last week, it appears that there had been a marked shift of market leadership from the directional flows of the US equity markets to the actions in the US dollar.

The recent breakdown of the US dollar to generational lows appears to have bolstered segments of the US markets that has been latched to the global outperformance scenario. Evidences seem to corroborate such theory as supported by the vigorous activities in global ex-US asset classes, surging commodity prices and even the record Baltic Dry Bulk index (indicative of strength of global trade).

This week, as the US dollar recovered some of its lost ground, the sluggish US markets had been propped up by a late robust rally last Friday on accounts of a jobs recovery in the US. Unfortunately, US markets appear to have been “lusting” for any tidbits of favorable news in support of the recent gains, such that the mostly government engineered improvements on the job statistics had been construed as “positive”. As we have said before, the adrenalin in today’s markets have been a function of government steroids.

Our belief is that the US FEDERAL RESERVE could be deploying tools to avoid from the furtherance of policy actions to reduce the risks of resurgent inflationary expectations amidst an economic growth downturn, prompted by the deepening housing recession. The attendant and continuing surge in prices of gold, oil, and other commodities, as well as long term treasuries yields have adamantly reinforced such expectations. Moreover, reduced expectations for additional policy actions could cushion the US dollar from a deleterious unwind.

As we have previously noted, US policy makers have repeatedly shown patent sensitivity to the performances of ASSET prices despite their repeated disavowal “to influence asset prices”. Hence, the apparent aim to implicitly bolster asset prices by indirect intervention, such as the recent spate of injection of liquidity, adjustment of policy rules—allows for a wider universe for eligible collateral and allows for a liquidity pass through from banks to their broker dealer subsidiaries and lowering of interest Fed rates. Aside from pent up activities of the Federal Home Loan Banks to fill up the liquidity vacuum.

You can also add to the list the possible manipulation of the recent employment statistics, where most of its gains came from government hiring, aside from the phantom birth/death ratio which accounted for 69% of non-farm payrolls, according to Paul Kasriel of Northern Trust. Thus, the recent breakout of major US benchmarks (Dow Jones Industrials +1.23% week-on-week, S & P 500 +2.02%, Nasdaq +2.92%) reduces the pressures to apply policy actions and this has started to reflect on FED futures as shown in Figure 2.

Figure 2: St. Louis Fed: Fed Rate Cuts Expectations

As we discussed in our Sep17 to 21 edition [see As The Us Dollar Falls, Stagflation Becomes A Reality], for as long as equity prices remain either on consolidation or on the upside the US FEDERAL RESERVE will likely be on a hold. As in the chart, this view has now generated some following as the gap in Fed rate futures (expectations) have narrowed relative to the actual FED policy rates.

In addition, recent communiqués from some Fed officials appear to give some meat to such outlook, this excerpt from Bloomberg, ``It would be a mistake for markets to bake into the cake the assumption of ongoing rate cuts,'' St. Louis President William Poole said today in New York.”

In short, the FED looks to hit an incredible FOUR BIRDS (not two) with one stone… shore up equity prices, lessen the impact of an economic decline, cushion the US dollar from a drastic fall and reduce inflation expectations. It’s quite an arduous rebalancing task, don’t you think?

In our view, there will be a spillage somewhere, as these delicate and fragile balancing acts by a reaction based bureaucratic leadership will most unlikely attain a Utopian climax. Palliative measures are almost always short term remedies, unless they are providential enough. However, given the FED’s predilections towards targeting asset prices, we are likely to see them err to the side of inflation or blowing more bubbles somewhere.

Anyway, over the broader market, the lagging sectors of the US benchmarks which represents internal woes, have played a catch up role last week, dispelling fears of recession risks. However, with the tidal wave of mortgage resets slated from October to the second quarter 2008 or in the coming 6 months or so, we remain skeptical towards the outlook that the US economy would remain impervious to these developments.

Phisix: Visible Signs of A US Dollar Driven Rally

``However beautiful the strategy, you should occasionally look at the results."-Winston Churchill, ex- Prime Minister and British Statesman (1874-1965)

THE bulls stepped into overdrive as the PHISIX surged for the third consecutive week to expunge ENTIRELY the latest global credit scare triggered losses and to retest its July LIFETIME highs at 3,800.

For the week, Phisix gained a stupendous 5.68% (!), but second only to Indonesia’s 5.99% for a cumulative breathtaking three week winning streak of 13.96%! What a fantastic comeback.

As we have previously discussed, empirical evidences suggests that the today’s captains of the global markets have been the principally fate of the US dollar. In domestic context, such framework applies, as shown in Figure 3….

Figure 3: USD/Peso-Phisix: Reasserting the Correlation

Both the Phisix and the Peso are at decisive junctures. On Friday, the Phisix (black candle) retested its July high at 3,800 and appears to be in the process of reestablishing a new milestone.

On the other hand, the USD/Peso (red line) has successfully broken below its July lows to close at Php 44.75 on Friday.

The chart shows of the negative correlation between the Phisix and the USD/Peso (blue block arrows), where a rising Peso coincides with the strengthening Phisix and vice versa. A caveat is that correlation DOES NOT imply causality.

Our supposition is that aside from monetary policies and trade or remittance flows, the Philippine Peso’s conditions signifies capital flows at the margins, where portfolio flows to Philippine assets meaningfully reflects on the price level of the Peso. The Phisix, being one of the asset classes (fixed income, and real estate), may reflect on such portfolio flows.

For the last two months, however, the said relationship has not been linear. As global markets agonize from the US subprime triggered credit seizure last early August, the Peso and the Phisix fell almost simultaneously, principally on the account of foreign instigated selling.

As you probably noticed, we identified how the Phisix rebounded ferociously and swiftly based on local support. Hence, you’d observe that the Phisix continued its ascent while the Peso struggled.

From September onwards, we observed that the Phisix resumed on its advances with a magnified degree of gains alongside the rise of the Peso. Foreign inflows, however, had NOT been reflected in the Phisix as the month registered a net foreign outflow (3 in 4 weeks!), aside from being relative net sellers (companies which registered foreign inflow-outflow) over the broad market. So, foreign money exchanges could have either seeped through the other assets or got stacked into bank accounts.

As we noted in the past, this has been one of the remarkable “FIRSTs” in the recent cycle, where previously local investors had been seen pushing mainly peripheral issues or on the Phisix issues for only over a relatively limited period of time.

The present recovery revealed of the sustained firepower by the locals, as they directed on the gains of the Phisix or had been responsible for the advance of the “capital intensive” market heavyweights in August through September.

We only saw the reemergence of foreign inflows into the PSE since Friday of last week, and have been inclined to attribute this week’s Phisix’s outperformance to these belated inflows as the US dollar index etched its fresh milestone lows.

Further, we noted in the past of the inherent strength of the local market would come along with the increase in active participations from its constituents. We are already seeing signs of this happening.

As an aside, our long stated notion that Asian money would eventually pour into the region’s capital markets as financial integration deepens combined with a potential realignment of the global capital flows dynamics, in as much as the continued strengthening of the region’s economic linkages.

China’s recent activation of its $200 billion sovereign wealth fund, the China Investment Corp, plus Japan’s potential to do same with Japan Post’s breakup and consequent privatization signifies the idiom of “getting down to the brass tracks” or of getting serious. Combined, these forces, barring any shocks such as resurrected protectionism, would drive the Phisix beyond our 10,000 target in the coming 5 years or so.

For now, the burst of local support has brought about marginal signs of decoupling from the US benchmark as shown in Figure 4.

Figure 4: stockcharts.com: Signs of Decoupling?

As local investors press on to lift the Phisix (candle) from its August lows, we note that the US broadmarket S & P 500 (behind) had been trading sideways, as shown by the circles, to manifest superficial signs of decoupling. Yet, all four benchmarks, the Dow Jones World (topmost) and Dow Jones Asian ex-Japan (lowest window) have been positively correlated.

Our idea is that for as long as the US manages as a soft landing the potential for this soft decoupling on a positive correlation could be maintained. However, if a hard landing occurs the initial reaction could be as destabilizing and almost similar to the July shock except that instead of a short time frame (two months) there could be a potential for a much prolonged torment (possibly a year or more).

Further, because of the lack of objective, comprehensive and in-depth information about valuation based approach to stock market investing, local retail investors have adopted mostly either momentum trading or “event” or “story” based punts which results to a greater number of trades, see figure 5.

Figure 5: Surging Trades Signifies Rise of Speculative Punts

Sellside and technical analysts who proliferate in our industry have heavily contributed to this surge in speculative punts, where little among these practitioners deal with prudent risk management. Only a minority of investors are aware of the cyclical influences of markets relative to the investing exercise of risk-reward trade offs.

Although the rise in the number of trades could serve as a measure for excesses in investor sentiment and signify as a potential tool for market timing, over the long term it would simply be natural to expect the rising trend of number of trades concomitant to an ascending market as investors will intuitively be drawn to winning trends.

Firming Regional Currencies and Revival of Carry Trades Bullish for the Phisix

``Asia’s riches and development, in fact, have been argued by historians to have been the basis for the growth and concentration of wealth and trade in Europe, particularly in Venice and Genoa.”- George Magnus, Senior Economic Advisor to UBS Investment Bank, quoted from the article, Sovereign Wealth Funds and the Rise of the "Global South"

In all, so far with global equity markets as the apparent beneficiaries of a struggling US dollar and a levered play on global growth, seasonal strength going to the yearend, aside expectations of continued global economic and financial buoyancy, liquidity inspired resumption of carry trades and heightened signs of inflation among key Asian economies as China, India and Singapore highlights the prospects for further currency appreciation or a liquidity spillover from unsterilized actions by central banks to limit currency movements.

In addition, even if the Bernanke’s FED were to pause from slashing of its interbank rates, economic growth prospects and interest rate spreads as well as interest rate expectations, are unlikely to be supportive of the US dollar, considering the intensifying losses in its real estate industry.

Except for the excessive investor sentiment against the US dollar, aside from its technically oversold position, the US dollar’s recently could be due to such transient factors.

Meanwhile, the Bangko Sentral ng Pilipinas (BSP) recently reduced overnight bank lending rates by 25 basis points in order to neutralize the implied tightening seen by the streak of the appreciating Peso aside from the possibly reducing the currency’s appeal for carry trade arbitrages, in our view.

Carry trades, or borrowing or shorting currencies with low yields and investing the proceeds into high yielding assets have been reignited on a global scale as the major funding currencies of the Japanese Yen and the Swiss franc has drifted lower amidst the appearance of stabilizing financial markets.

Surging emerging assets, global equities and commodities coincidental to the decline of the funding currencies could be empirical indications of the renewed activities in such specialized highly speculative trades.

A rise in volatility frequently coincides with the rise of these funding currencies as the levered positions utilized by such cross currency arbitrage get closed alongside with the corresponding liquidations of the assets invested.

The Fed’s move to drop interest rates has likewise caused other central banks to procrastinate from normalizing interest rates such as the Bank of England, and European Central Bank. The Bank of Japan is expected to keep on hold its rates too. Remember, these four central banks control policy rates for about 95% of the world’s international bonds and nearly all of the financing for international trade and financial markets, according to Cumberland Advisors’ David Kotok.

So the combined policy accommodation seems to have restored the inflationary speculative cycle.

And our thinking is that instead of manipulating the currency movements, the BSP or the local central bank has lowered rates to reduce the yield spread to prevent further appreciation caused by mounting incidences of carry trades.

However, the backstop of liquidity signifying continued strength in the region is likely to diffuse into Philippine assets barring any further credit shocks or deterioration in the US economy.

The short term risk is the technically overbought conditions could lead to an interim correction which should provide us ample opportunities to reposition or reenter.

While we maybe cautiously bullish on the markets over the interim for the abovestated reasons, don’t forget to invest only the amounts of risk you are willing to absorb.

Present conditions, such as a potential hard landing in the US or another bout of credit seizure or ripple effects from a violent US dollar unraveling or a sudden bust in China’s markets, are prone to shocks, whose risks should not be taken for granted.

Present conditions likewise allow us to position to take advantage of short-term trades as well as to position for a longer horizon. Invest prudently.