``We citizens will remain pessimistic about the future. That’s our way. And that pessimism is exactly what we need to drive the technological advances that will bring the Golden Age. If we trusted the Golden Age to come on its own, it wouldn’t. It will take a lot of work. Luckily, that work is happening.”-Scott Adams, Dilbert
My daughter likes to watch horror movies. Her past problem was that each time she watches these, fear gets to overwhelm her such that she won’t be able to sleep or stay in a room by herself. This requires my presence at her side. Thus, each time I encounter her watching such genre of shows, I constantly remind her that “these are only movies” or that screenplays depict on the plots engendered by the film producers to entertain viewers.
Logical Fallacies and the Ludic Fallacy
Many analysts limn today’s investment landscape like a horror movie. They predict that the world will segue into a deflation induced global depression-your financial world Armageddon. Their simplified basic premise as follows:
The US is undergoing a “deflationary spiral”
Since the US functions as the most significant economic growth engine to the world
Hence the world will also fall into a US led-deflationary depression.
While their arguments or what we call as the Dry Bone deduction (toe bone is connected to the ankle bone is connected to knee bone…) presents a compelling case, we share Nassim Taleb’s dyspathy towards Mental Mapping. To quote Mr. Taleb from his magnum opus, The Black Swan (emphasis ours) ``We worry about those that happened, not those that may happen but did not. It is why we Platonify, liking known schemas and well-organized knowledge-to the point of blindness to reality. It is why we fall for the problem of induction, why we “confirm”. It is why those who “study” and fare well in school have a tendency to be suckers for the Ludic Fallacy.”
Further, such arguments seem to fall under logical fallacies of “begging the question” and the fallacy of “division”.
Begging the Question is (nizkor.org) `` a fallacy in which premises include the claim that the conclusion is true or (directly or indirectly) assume that the conclusion is true. This sort of "reasoning" typically has the following form”. Or essentially, an argument whose conclusion is its basic premise.
Meanwhile, the fallacy of Division (wikipedia.org) ``occurs when one reasons logically that something true of a thing must also be true of all or some of its parts.” Or the belief that the US equals or is the world- via the basis of tight interdependence.
The basic premise that the US financial system is presently undergoing a credit contraction, which is defined as deflation, is quite accurate. However, the assumption of the trajectory of its present activities will be transmitted to the world through the linkages of trade and finance is highly questionable in our view.
Moreover, depression advocates could be overestimating the inferred impacts of such linkages and at the same time underestimating the potential effects of government actions. This is not to suggest government actions will succeed which we think will not. Instead government actions out of the political demand to mitigate any crisis or dislocations could lead to unintended consequences.
While we fundamentally agree that every credit driven booms eventually result to catastrophic busts, we find the intense obsession towards the paradigm of Japan’s “lost decade” or the 1929 depression as undeserving.
Mistaking such maps or models for reality is what Mr. Taleb describes as the “Ludic Fallacy”.
Analyst Viewpoint: Rearview Mirror or Windshield Outlook?
The fact that the mortgaged induced securitization-derivative implosion has roiled some major developed markets and economies today should not extrapolate that the rest of the world will follow the same path.
For instance, as we pointed out in our previous issues the Philippines have little exposure to such toxic wastes; missed out entirely the recent global real estate boom (see Figure 1), have been reducing its debt levels (public and private), have seen its forex reserves surge in consonance with its Asian neighbors, a belated upsurge in the Peso and saw its stock market up by only about 260% during the past 4 years-which is hardly symptomatic of a bubble.
Figure 1: ADB Bond Monitor Real Estate Loans as % to Total loans
Besides, our belated reaction to the property boom appears to be cyclical; it took years to cleanse out the malinvestments in the system following the Asian Financial crisis.
Yes, a hard landing in the US will surely impact the world but to a different degree than the depression advocates have been projecting.
Next, previous crisis have shown different impacts to global markets.
Figure 2: Select Global Markets: A Rendition of Past Performance?
Figure 2 shows of the different equity benchmarks over a 20-year time frame. The Philippine Phisix (Green), US S & P 500 (black), Japan’s Nikkei 225 (blue), Hong Kong’s Hang Seng (violet) and Brazil’s Bovespa (red).
Our intention is to show how markets performed during the previous crisis in parts of the globe and its interrelation with other markets.
Depression advocates have been deeply enamored with Japan’s bust as a model, yet in 1990, the sharp drop in the Nikkei (blue top) has not impacted significantly much of global markets. In hindsight, one may argue that given the nascence of financial globalization and lesser trade or financial linkages by Japan’s economy relative to the world, a slump in Japan’s economy and markets had not meaningfully been transmitted to the world.
In fact, what transpired appears to be a shift-a boom in ASEAN markets and economies, represented by the Phisix and in Latin America, represented by Brazil.
The boom in ASEAN had been corollary to massive Japanese direct investments seeking out low cost production cost as an offshoot to the 1985 Plaza Accord, aside from hefty portfolio flows from US, first generation Newly Industrialized Countries of Asia (Taiwan, Korea, Hong Kong) and other foreign based funds in search for higher yields. As with all credit driven booms, following Latin America’s Tequila Crisis and the Asian Financial Crisis, ASEAN and Latin America equity benchmarks collapsed.
As Asian markets wobbled from the double whammy of Japan’s collapse and the ASEAN bubble implosion, what transitioned was a boom in the US led the technology sector or that global fund flows found its way into the US markets.
The dot.com bust in 2000 was the first concrete manifestation of synchronized markets (blue arrow and left light orange vertical line) as the Phisix, Bovespa, Hang Seng, Nikkei and the S&P all suffered declines but varied on the degree of losses.
Following the erstwhile Fed Chair Alan Greenspan’s drive to forestall the menace of “deflation”, the Federal Reserve slashed its rates to a 60-year low at 1%. Such policy actions stoked a reversal (blue arrow and rightmost light orange vertical line) in favor of the bulls, which saw diverse asset classes (bonds, stocks, commodities, collectibles-paintings stamps wines etc.., real estate) across the globe markets soar in near simultaneous fashion.
Thus, global depression advocates appears to have “anchored” their analysis using the recent past performance of tight correlation (in 2000-2006) as their basis for forecasting a global gloom and doom scenario. Such recency based analysis is called by Warren Buffett as the Rear View Mirror syndrome, to quote the Sage of Omaha, ``In the business world, the rearview mirror is always clearer than the windshield.”
Windshield Outlook: NO Signs of Global Depression Yet
Now looking at the windshield we ask, what has transpired so far over the decades was divergent markets which eventually evolved into convergent markets…our $64 trillion question is, will the past performance do a reprise?
As an aside, I am guilty of the same mistake of interpreting past performance for future outcome last year. When the first symptoms of the mortgage-securitization crisis appeared, I initially panicked out of the thought that local investors, who remained subordinate all throughout this cycle or since 2003 until mid-2007, would not provide for sufficient volume enough to match the equivalent intensity of foreign selling, hence increased the risks of a market collapse. Although, I expected local investors to pick up their volume eventually as we argued in 2006, the lack of consistent material evidence during the boom since 2003 rendered me a skeptic on the locals’ capability to shore up the market especially under duress, thus, the misread.
Nonetheless, 2007 proved to be the first instance where local investors proved their moxie, which again as discussed last week, should be a bullish underpinning. Once the sentiment of foreign returns in our favor, bullish locals plus bullish foreign money should propel the Phisix much higher! But, again, the ultimate question is one of timing-when will foreign money will reverse their sentiment?
As we all know, 2008 has started out negatively, with most major global equity markets suffering from the knock on effects of the credit triggered turmoil in the US financial markets.
While the impression portrayed is that the world is presently “recoupling” based on the woes of the US, we do not want to succumb to the fallacy of being blind to the “reality” that some markets appears to be in fact, “decoupling” from the US as shown in Figure 2. We will follow Warren Buffett’s advice of focusing at the windshield.
Figure 3: stockchart.com: BRIC countries Recoupling or Decoupling?
Figure 3 shows us that even while major developed markets have seen their equity benchmarks in a downdraft, contemporary benchmarks of major emerging market protagonists categorized as the BRIC or Brazil, Russia, India and China have still been ascendant if not remain at elevated levels in spite of the recent bouts of credit driven financial market tremors. This prompts us to ask; are the BRICs “recoupling” or “decoupling”?
As we have repeatedly mentioned, deepening financial globalization trends effectively works to integrate various economies through trade and financial mechanisms. Put differently, in today’s globalization trends markets and economies are likely to have greater degree of interdependence relative to the past, hence any shock could impact countries varying on the depth of their exposure to such trends.
But the important caveat is that countries are structured differently in terms of trade, financial markets, economies, fiscal and monetary policies and governance such that there is no such thing as a perfect correlation or integration. Such distinctions matter a great deal.
I have repeatedly used Zimbabwe as an example. Zimbabwe suffers from consecutive years of economic recession (unemployment rate at 80%, 30% contraction of GDP over the past seven years-voanews.com) which has resulted to a hyperinflationary depression-with present inflation raging at 24,000% (earthtimes.org), prompted by political repression. But guess what? Despite the standstill in its economy, where businesses appears to have grounded to a halt, its stock market soared by an astounding 300,000%, particularly 322,111% in 2007!
Why? Because of government policies. The argument is not about the size of its economy but rather how government policies influences markets or economies. It’s not your run-of-the-mill narratives impelled by economic or corporate forces as most analysts or experts suggest. It’s about the unintended consequences of government policies or activities on the marketplace and the economy. The shriveling value of the its currency, the Zimbabwe Dollar, effectively translates to a functional loss of its monetary role of “store of value”. Thus, the currency’s negative yield or the effective loss of purchasing power prompts for a substitute or a search of value greater than the currency-found in the form of company stocks.
As Ludwig von Mises in his Theory of Money and Credit observed (highlight mine), `` …a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time.”
This brings us back to our earlier assertion that monetary policies adopted by the US Federal Reserve pumped up prices of diverse asset prices across the continent; if monetary policies influenced global assets in the past can they not influence in the same manner global asset policies at a dissimilar scale?
Depression advocates insist that no, fiscal and monetary policies will end up in the same route as the Japan experience.
Here is a monumental quote from Treasury Henry M. Paulson, Jr. during a speech at the Asian Society last December 5 (highlight ours), ``Some in China are suspicious that the U.S. push for RMB appreciation and financial market liberalization is really an attempt to gain trade advantages and generate profits for American companies while slowing China’s economic expansion. They mistakenly believe that yen appreciation during the mid-1980s caused Japan’s weak economic performance in the 1990s. Rather, we now know that Japan’s economic difficulties were caused by the growth, and then collapse, of a huge stock and property price bubble, and the failure to use monetary policy to prevent the emergence of deflation after the bubble burst.”
Or how about this from Fed Chairman Ben Bernanke’s recent speech (New York Times), ``We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”. (highlight ours)
See what I mean? US authorities are in the belief that “appropriate” policy responses will serve as the much needed elixir to its present strains, and would act accordingly.
Now of course, the bag of tricks with which they intend to utilize could be expected to be far more than the traditional tools than we know of, given their understanding of the inadequacy of Japan’s policy responses (ZIRP, Quantitative Easing, massive pump priming).
Bernanke’s Helicopter speech is just a manifestation of the unconventionality of instruments they are willing to experiment with. Some of the recent examples of the new policy responses applications, the Term Auction Facility (TAF), Federal Home Loan Banks, aborted Super SIVs, swap agreements, changes in procedural rules and collateral and lending policies and others.
The point being that the future actions by US authorities will depend on its tolerance to meet the political demands of the whimsical voting public. In an election season, the inclination is to be more accommodative. However if conditions turn for the worst, where authorities will reactively pan to the public’s outcry for the mitigation of their economic or financial woes, then Bernanke’s hyperbole expression of turning to “helicopters” may be realized but in different forms, possibly through a cocktail of policy responses such as outright subsidies or bailouts, nationalization, price controls, capital controls, increase in borrowings to fund more welfare projects, increase government hiring, taxes etc.. Desperate measures for desperate times.
And upon such actions will correspond to the unintended consequences in the US and elsewhere abroad, where the transmission channel should mainly be through the US dollar- as the world’s reserve currency. Thus, the impact from such policy responses is likely to be divergent.
In the ASEAN region its equity markets have responded divergently too, as shown in Figure 4.
Figure 4: stockcharts.com: ASEAN Markets: Recoupling or Decoupling?
While the Philippine Phisix and the Thailand’s SETI appears to follow the actions in the developed world which means that they have been falling too, Indonesia and Malaysia’s markets have amazingly turned higher. In fact, Malaysia’s stocks, signified by Dow Jones Malaysia Stock Index (upper pane) appear to have shifted into an overdrive following its significant breakout last week on the account of heavy foreign buying (Reuters).
Don’t ask me for particulars why foreign money has started to prop up these benchmarks, I have nary an idea. Nonetheless, what we understand is if ASEAN is “recoupling” with the US then eventually the outliers or the present winners will reverse to reflect the path of the US markets, but if the present “decoupling” trend will be reinforced then we think that the Phisix and Thailand’s SET will likely follow the direction of this year’s leaders. As you know a decoupling strengthens our outlook for a Phisix 10,000 on a backdrop of surging Asian markets.
More to the point, if one looks at equity flows during the 2007 financial maelstrom, data from emergingmarketportfolio.com tells us why ASEAN or BRIC countries remain at lofty levels as shown in Figure 4.
Figure 5: courtesy of EPFR Global: Emerging markets as Safe haven?
In the past, we have shown you how some emerging market debt instrument have shown lower yields (priced on the basis of lesser risks) compared to that of US financials where the implication is that emerging markets have now become some sort of a “safe haven” [see November 19 to 23 edition, Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?]
Figure 5 from EPFR shows (right pane) how Dedicated Emerging Market Funds and International Global Markets have attracted capital flows at the expense of the US, Japan and Western Europe, despite the recent volatility.
In addition, on a sectoral basis, commodities/basic materials (right pane) continue to attract capital investments again despite the recent storm. The former laggards seen in the technology sector following the bust in 2000, appears to have shown signs of a steady recovery, while financials and real estate continues to cascade. On the other hand investment flows to the energy sector looks sluggish.
For the week ended January 9, AMG Data says that the inflows towards emerging markets continues to validate the present “decoupling” trends in BRIC and ASEAN markets, this from AMG, ``Excluding ETF activity International funds report net inflows of $396 million as net inflows are reported in all Emerging and Developed regions except Latin America (-$10 Mil) and Europe (-$41 Mil)”
Meanwhile the Institute for International Finance (IIF) a financial outfit consisting of 370+ members in 65 countries projects capital flows towards emerging markets to moderate but remain vigorous (Morningstar.com), ``The IIF expects the volume of net private capital flows to emerging markets in 2008 to reach $670 billion, which represents only a modest dip in capital compared to the record $681 billion reached in 2007. The IIF estimates that the volume of net private capital flows to emerging markets in 2006 totaled $560 billion.”
To consider, as the world continues to massively print or generate money or liquidity as shown in Figure 6, these are likely to find a home.
So indeed while the US has been encountering some signs of “credit contraction” via its dysfunctional financial system, other parts of the world are still massively producing liquidity and perhaps could be the reason why we are seeing signs of divergences.
Not My Grandpa’s Deflation
Besides, Peter Schiff of Euro Capital provides an important insight why such horror stories are likely to be a US centric problem than a world problem. Quoting at length Mr. Schiff from his trenchant article Not Your Father's Deflation (emphasis ours),
``However there are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing…
``Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.
``In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege…
``The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors. Since American debtors can vote in U.S. elections and foreign creditors can not, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage.”
Prediction Dilemma: The Fox versus Hedgehog
Could the depression advocates be correct? Of course they could, although we assign a smaller probability to such scenario. That is why it is highly recommended for an investor to stay defensive during these turbulent periods, which means investing only the amount of risk that one can afford (by position sizing), even if we are long term bullish over Philippine or Asian stocks.
At present, in the battle between inflation and deflation markets appear to be signaling another form of ‘flation’…stagflation. Eventually the markets will tell which among these scenarios will dominate.
You see the debate about the merits of an inflationary or deflationary outcome is basically a problem of making predictions.
Another favorite analyst of ours Josh Wolfe of Forbes Nanotech identifies two types of prognosticators, a Fox and a Hedgehog, where according to Mr. Wolfe, ``Foxes are skeptics and less confident in making predictions and build a latticework of mental models. Hedgehogs are more enthusiastic (especially about what they know) and more confident in making predictions and then pushing those predictions into all domains. As you’ll see, the quick brown renaissance Fox jumps over the staunchly opinionated Hedgehog…”
Hedgehogs tend to be radical theorists in terms of forecasting and are frequently wrong than right, which today we find relevant in the advocacy for a global depression, quoting anew Mr. Wolfe (highlight ours)…
``Some hedgehogs are often seen to predict big extreme changes. Not because they are more prescient, but they are tend to be in a minority of opinion holders for an outlandish outcome. But those outlandish outcomes are important to have out there. Hedgehogs cling to very extreme assignment of odds to something: i.e. it absolutely will never happen: 0% or it is certain to happen: 100%. As the saying goes, even a broken clock is right twice a day. The cost of being a hedgehog is a lot of false positives. They constantly predict some certain outcomes, but they are more often wrong as most do not ever occur: (remember Dow 36,000?). Hedgehogs are also more likely to be on TV as talking heads because they are more confident, more assertive and assign higher probabilities to low frequency events—which also make them more interesting to watch than someone who is more reserved.”
In our case, we’d like to emulate the fox, always studying the different scenarios or models advocated by different hedgehogs and parlay our risk according to the probability of its occurrence. The bottom line is while extreme events or “black swans” may indeed occur, the odds are stacked against such scenarios, and most especially when the scenarios projected seem to be grounded on logical fallacies.
So when we hear or read depression proponents preach about the collapse of the world, until now, it remains to be just that…a movie plot.
Figure 7: Prieur Du Plessis/GaveKal: Gold’s Rise has been correlated with the 
