In A Crisis, Be Aware Of The Danger But Recognize The Opportunity

``Hope and denial do not constitute a successful investing strategy. More money is lost by people listening to their emotions and ignoring facts than is lost because of just about any other influence.”-Bill Fleckentstein, MSN Money Contributor

ON the road to vacation, I chanced upon a rather queer article from a veteran stock market analyst on a business broadsheet. The narrative incited for local market participants or the purported “weak” hands to “panic” so as to “end” this dreadful bear market. Obviously, the bizarre straw man argument undeservingly nitpicked on the domestic players when it is the foreign participants mainly responsible for the recent carnage.

While the essay appeared to be a “reverse psychology”, which was meant to do otherwise, it signifies pretty much of a deeply entrenched state of denial-the inability to accept the persistence of the present conditions. This seems to reflect signs of impatience and deepening frustration from a supposed market expert. As German-Swiss author poet Hermann Hesse in his novel Steppenwolf wrote, ``All interpretation, all psychology, all attempts to make things comprehensible, require the medium of theories, mythologies and lies."

As discussed in last week’s Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist”, since the Philippine financial markets has not evinced signs of a reversal from its internal or “local” cycle but rather has been reacting to the impact of bubble implosions (real estate and securitization) abroad, we are likely to be undergoing a typical “corrective” countercyclical phase than of a secular turnaround.

The point is to understand the underlying cycles driving our markets than speciously look for momentum and sentiment driven reactions and rationalization. To wit, the spate of foreign driven selling has been prominently impelled by “forced liquidations” of institutions in a frenetic effort to raise or shore up capital or meet margin requirements as lenders tighten up or fulfill investor redemptions, which translates to selling of the most liquid and even safest papers.

To quote the Economist (highlight mine), ``The fear is that the financial markets have entered a negative spiral with being forced to sell bonds and loans, whether or not they believe the borrowers will eventually repay. The problems are exacerbated by the demise of the securitisation market, and fears about counterparty risk. Both those factors are making banks less willing to lend—even to worthy borrowers. They will become even more cautious the deeper America’s economy tips into recession.” For example, Louis-Vincent Gave of Gavekal Research notes, ``tax-free AAA municipal bonds started to yield more than the equivalent US government bonds. Given the tax differentials, this makes no sense at all.” (emphasis mine)

As you can see the consequent fear and the forced offloading, which signifies a hoarding effect is a natural consequence of the breakdown in the securities market, has distorted the pricing of securities in the world financial markets. And under a globalized environment, we are feeling the heat of such contagion, so as in most parts of the world.

Secondarily, “adjustments on effective valuations” emanating from the perceived economic slowdown in the wake of the evolving debt crisis is another variable from which global markets appear to be exhibiting.

This cyclicality is best illustrated by the description of Citibank’s Credit strategist Mark King of the four phases of a credit cycle (hat tip: David Fuller). Quoting Mark King (underscore mine)…

`` Phase 1: Long credit, Short equity

``This phase immediately follows the bottom of the credit bear market. Spreads fall sharply as companies complete the process of repairing balance sheets, often through deeply discounted share issues (as we saw for Insurance and Telecom companies back in 2002-03). This, along with continued pressure on profits, keeps equities weak.

``Phase 2: Long credit, Long equity

``The next phase begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflow rises strongly. We call this an immature equity bull market. For the present cycle, this phase began in March 2003 and finished in the middle of the 2007.

``Phase 3: Short credit, Long equity

``The credit bull market is over, balance sheet leverage increases, spreads rise, and investor appetite for credit wanes. Financial market volatility rises. As we progress through Phase 3, the equity market eventually decouples from credit and continues to rise. This is the mature equity bull market.

``Phase 4: Short credit, Short equity

``This is the classic bear market, when equity and credit prices re-couple and fall together. It is usually associated with falling profits and worsening balance sheets. Concerns about insolvency plague the credit market, while broad profit concerns plague the equity market. A defensive strategy is most appropriate - cash and government bonds are the best performing asset classes.

The credit cycle as defined by Citibank’s Mark King suggest to us that the US is most likely in Phase 4, as shown in Figure 1.

Figure 1: St. Louis Fed: Panic in Wall Street-Fed Pushing On a String?

3-month Treasury rates have plummeted close to zero or to three fifths of one percent (blue line), even as Fed funds is now at 2.25%. If Fed rates (red line) historically track the performance of 3 month treasuries (as far back to 1982) then they appear to be signaling Fed rates at one percent or below. Wow, such panic seems written all over Wall Street! But the stock market hasn’t demonstrated the same degree of fear. So our guess is that one of them (stock market or bond market) could be wrong.

But the question is how much more room can FED policies adjust before the market responds favorably? In other words, conventional policies appear to be losing traction even as FED rates are approaching zero. Hence, the risk of “Pushing on a String” or Fed’s policies pushing on one end does not appear to produce the desired movement at the other end. For Keynesians it is known as the “Liquidity trap”, where the next step would probably be our version of TSLF or Total Socialization of Losses of the Financials or Bernanke’s Helicopter Money.

Likewise the 5 year Treasury Indexed Note (green line) or TIPS is now at negative yield territories, where to quote Bill Bonner of the Daily Reckoning, ``These TIPS provide protection from both enemies – inflation and deflation. The feds won’t default. And the TIPS adjust to losses in consumer purchasing power – as calculated by, well, the feds themselves. But so great is the demand for this kind of protection that investors are willing to give up all hope of a current yield in order to own them.” (emphasis mine)

All this goes to show how global investors have indiscriminately dumped most assets and gravitated or shifted towards safehaven issues in search of a protective shelter from the prospects of both defaults or deflation and inflation.

Nevertheless, based on the Mark King’s Credit cycle, the US and other heavily levered developed economies appears to be in phase 4 as the credit losses deepens, while the Philippines does not share the same fundamentals.

On the contrary we seem to be situated in between the Phase 1: Long credit, Short equity and the Phase 2: Long credit, Long equity of the King credit cycle as evidenced by repairing of balance sheets, greatly reduced leverages, exploding foreign exchange reserves, declining fiscal deficits, falling yield spreads, rising cash flows…all of which seem to suggest that fundamentally we do not share the same flaws as the external influences affecting us. Thus, instead of fear and denial, today’s credit crisis ought to be seen in the light of opportunities which may be lurching at the corner. After all, it is all a matter of perception.

In a speech in Indianapolis, April 12, 1959, former President John F. Kennedy (1917 - 1963) conveys of the best lesson one can learn from a crisis, ``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity.”

Voyaging The Unexplored World With Incomplete And Outdated Signposts

``I think there’s also a very real possibility that a lot of trouble could lie ahead. And at least my view, since we’re in uncharted waters, and I don’t think there’s a way to make a probabilistic judgment about where you are in that spectrum, I think we need to take these risks very seriously and I think that we should – from a policy perspective – take whatever measures we can find that we think are sensible to try to reduce that risk.”-former Treasury Secretary Robert Rubin quoted on WSJ blog

Next, we also find the recurring talks of the nominal measures of bear markets or of how the Philippine markets will react as the US enters into a recession. The idea is that US recessions or bear markets assume some quantifiable depth or duration dimensions that allows for the extent of the market stress to be identified. Such is premised on the assumption that historical performances are likely to repeat itself with near exactitude. The fallacy of this “appeal to the tradition” is where certain analyst projects the traditional-seen via lens of the “averages” or “median” of past activities-as the potential outcome for our market.

Figure 2: Bespokeinvest.typepad.com: Declining Duration of Recessions

As shown in Figure 2, courtesy of Bespokeinvest.typepad.com, over the past 100 years US recessions have been in a decline in terms of duration (days) or have become shorter. To quote Bespoke, ``For example, three of the first four recessions during the 20th Century lasted longer than 600 days. During the last four recessions, however, only one has been longer than 250 days (the longest was 487).” Some say that the average recession lasted by about 11 months while a severe recession extends up to 16 months (allbusiness.com).

While indeed the general trend has been down, you’d notice that there have been instances where the length of the economic contraction overshoots the declining trend (1929, 1973 and 1981). Thus, such trend does not signify today’s performance as a foolproof indicator that if the US will enter or is undergoing a recession today, the duration will be short, shallow or will be in within the “average” or “median” context.

Another, selecting reference points as indicator for the duration could be a point of contention. Biased analysts can or will use certain reference points to prove their case.

Figure 3: The Bear Market Cycle of the Phisix, Nikkei and the Nasdaq

Figure 3 shows of the different recession instigated bear market cycles.

For instance, the Phisix (top most chart) in the aftermath of the 1997 Asian crisis fell by about 66% from peak to trough in a span of 19 months. The blue arrows point to the interim or short term bottoms which biased analyst could utilize to prove their fallacious case of short bear cycles.

Since no trend goes in a straight line we saw the Phisix rebound sharply coincident with the assumption of a new President in 1998. Eventually the rebound tapered off and the Phisix resumed its long term bear market until 2002.

A similar case can be drawn from Nikkei’s first leg down (middle chart). After 62% loss in 31 months, Japan’s Nikkei appeared to have consolidated and bottomed out. However, the grizzlies shred up the bulls which eventually compounded the losses to about 80% (from the peak) in 13 years!

The dotcom bust is the same story (lowest chart). The full bear cycle of the Nasdaq saw its index fall by 75% in 30 months or over two years, where as shown above there had been four minor bear cycles juxtaposed with 3 countercyclical bullmarket within the secular bear market cycle.

Figure 4 Northern Trust: The Business Cycle and the S & P 500

Figure 4 shows of the interplay of the Business cycle with that of the S & P 500, courtesy of Northern Trust.

While one can compute for averages or medians, data shows that they hardly fall within the exact spots. To add, bear markets cannot simply be “boxed” or sterilized into “averages” or “median” simply because the driving factors from which the imbalances accrue and unravel were unique.

Further, the assumption of the averages or median does not even consider the underlying conditions that engendered the best and the worst case scenarios which eventually gets built into the equation of “averages” or “medians”.

Such is the reason why many investors including those armed with sophisticated math models get burned simply because they give weight to experience of the recent past (rear view mirror syndrome) or interpret data to fit their biases (confirmation bias).

Little have made use of the characteristics of a “Taleb distribution”, named after the Nicolas Taleb, author of the Fooled by Randomness and the Black Swan where as defined by Martin Wolf of the Financial Times, ``At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.” Giving undue emphasis to high probability events with modest gains, while ignoring risks of huge losses from a statistical deviation is a recipe for heavy portfolio losses.

Moreover, do any of today’s economic conditions or financial markets manifests of the so called averages or medians (see Figure 5)?

Figure 5: Economagic.com: Average? What Average? Where?

Not quite the average. Gleaned from the financial markets perspective, prices quoted or as reflected in its trends today do not reflect “typical” periods; the US dollar is on a milestone low (olive green line), 10 year US treasuries yields are knocking at a fresh multi-year lows, Energy prices (red line) are on the roof while precious metals (blue line) have just recently etched record highs even after the recent selloff.

So none of these appears to show significant correlation as with its contemporary past performance.

Figure 6: Danske Bank: BRIC versus OECD/yardeni.com: Exploding forex reserves

Even from the economic perspective, the outperformance of emerging markets relative to economic growth and reserves are other aspects of incomparable developments.

Figure 6 from Danske Bank shows the Leading Indicators of BRIC outperforming the OECD countries, and so with the exploding foreign exchange reserves of developing countries relative to industrial countries from yardeni.com.

Furthermore, consider the risks arising from Derivatives, notes Martin Weiss of moneyandmarkets.com (emphasis mine),

``At U.S. commercial banks alone, the total notional value of the derivatives is $172.2 trillion, according to the latest report by the U.S. Comptroller of the Currency (OCC). Plus, the OCC reports that:

``In over 90% of these derivatives, there is no established exchange that helps protect either party from default.

``Just FIVE major U.S. banks control 97% of all the bank-held derivatives in the United States, a concentration of power — and risk — unsurpassed in the history of finance.

``All five of these major players would likely be severely crippled, or even bankrupted, by the default of just a few major counterparties like Bear Stearns.

``Four have more credit exposure to counterparty defaults than they have capital.

``Two have over four times more credit exposure than capital.

Needless to say, derivative exposure by the US financial system to derivatives is unequaled in history. Yet, the loss estimates on the financial sector from the evolving mortgage-securities-derivatives crisis seems to be mounting: from $100 billion by Fed Chair Bernanke last July, $500 billion from Goldman Sachs now $1 to $2 trillion from Nouriel Roubini of New York University’s Stern School of Business!

Moreover, as the world’s biggest banks have absorbed $US195 billion in writedowns and losses on securities tied to subprime mortgages, Credit Suisse Group calculates that the 10 biggest US banks have the lowest capital levels in at least 17 years (theage.com.au)!

All of these go to show how today’s circumstances have simply been unprecedented. So how does the unparalleled or extraordinary circumstances equate to “averages” or “median” as sold by analysts is beyond me.

As a caveat, this doesn’t imply that we are bearish but instead recognize the risks involved under the current circumstances are totally different from any period of time to make valid comparisons.

Dr. Marc Faber discusses the discerning insights of market sage Peter L. Bernstein, author of the magnificent book Against the Gods, the Remarkable Story of Risk (a must read for market practitioners).…

This lengthy but fitting quote from Dr. Faber…

``Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled “Uncharted Territories” that “the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health... There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969.”

``Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of “strains in the resources of the system, such as high levels of capacity utilization and low unemployment”. (Peter Bernstein has developed a “Strain Indicator”, which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator “has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs”.)

``But Peter Bernstein isn’t optimistic about the economy. In asking himself the questions “what is going to happen next?” and “what is the outlook?”, he explains: “[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us.”

``In referring to some of the unique features in the current scene – mentioned briefly above – Peter opines:

`` [W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer’s piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture – drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up.”

``The author Dave Wilbur has said: “One of the world’s greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it.”

``Similarly, Peter Bernstein concludes his report with the observation that “there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster.” During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: “There are old pilots and there are bold pilots, but there are no old, bold pilots.” Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.”

Figure 7: Northern Trust: Largest Fed Cuts (in percent) since 1982!

Even monetary policies applied to the present circumstances by the US Federal Reserve has been relatively unorthodox, unconventional or most aggressive by historical measures (the use of depression era laws to rescue Bear Sterns, aside from the emergency lending policy bypass used by the Fed to accommodate lending for securities firms at a similar rate to commercial banks underscores the severity of present conditions).

This form Asha Bangalore of Northern Trust (highlight mine)…

``The Fed’s record in the August 2007 – March 2008 period will probably go down in history as the most aggressive and creative. The TAF, TSLF, and PDCF programs are its creative endeavors aimed at reducing the credit crunch and liquidity problems, while the sharp reduction in the federal funds rate is the aggressive feature of monetary policy changes in recent months. The FOMC has reduced the funds rate 300 bps between September 18, 2007 and March 2008. In nearly 26 years, such an eye popping drop in the federal funds rate in a seven-month period occurred only between August 1984 and March 1985 during Chairman Paul Volcker’s term.

``In terms of a percent change, the latest 300 bps cut in the federal funds rate is the largest (57.1% drop) since September 1982. The only period when it was close to the recent drop was a 55.5% decline in the seven months ended November 2001.”

In sum, all of these should extrapolate to a cautious, conservative and defensive stance as well as its accompanying actions aside from adopting open mindedness and flexibility than get suckered by our biases.

Remember, voyaging in unexplored territories means that we have little clue of what to expect and of the risks we are faced with. But learning from Warren Buffett simply means we cannot afford to freeze and should face up with the circumstances, ``On fears of a crash or meltdown or bad things happening in the market…Something bad will happen, but you could go back at anytime in the last 100 years and say the same thing...you can freeze yourself out indefinitely.’ Every investor must play the hand he is dealt.”

The debt crisis abroad is actually a process where non productive or speculative debt or Ponzi debt structure (Minsky model) is being destroyed. Eventually this “destructive process” will reach a culmination point where economic activity may be able sustain the level of debt in the economy, thus the storm will pass, as the contagion “forced selling” effect would have peaked-as with any normal cyclical transitions. It is not the end of the world as we know it, but part of a necessary market cleansing process. It does take time though.

We are not a stranger to this (go back to figure 3); the Phisix confronted the same phenomenon during the Asian Crisis of 1997 and agonized for 6 years. Japan’s Nikkei had a horrid 13 year of painful adjustments from such unsustainable debt levels. The Nasdaq crash took over 2 years to recover and was also a consequence of outsized leverage but restricted to the corporate sector.

All we can say with a little more definitiveness is that the continuing financial crisis will demand more actions from the authorities to the point of undertaking massive subsidies from which the latter would comply. The Financial Times says that major Central Banks are now discussing ways to absorb mortgage losses using taxpayers money to fund the losses!

The problem with this route is one of the unintended or unforeseen effects of more interventions (moral hazard, probable path to hyperinflation or global depression, extreme currency debasement, bubbles in new assets and others) from which may extend or defer the day of reckoning of the present imbalances from taking its natural path of adjustments or which may exacerbate the systemic risks to even more vastly unsustainable levels.

Yes, while cyclical divergences allow us to be more confident of the future relative to the fundamental standpoint of domestic or regional economy or markets, it would be best to heed the prudent advice of Mr. Peter Bernstein and Dr. Marc Faber who posits that we should avoid the road to disaster by eluding the presumption of knowing with absolute certainty what the future holds, based on incomplete and outdated sign post that go by.

To our understanding the domestic market is undergoing a normal countercyclical interim bear market phase as it is digesting both the pressures from the credit instigated losses abroad and the necessary adjustments from the valuations standpoint predicated from an economic downshift. But considering the cyclical aspects of the domestic economy and the local financial markets we are likely to be operating from a secular bullmarket until proven otherwise, although risks from the unexplored global conditions should dictate for more prudent actions.

Last, we should be aware of the incentives of the proponents of the both extreme scenarios, since many of them thrive on business models which require the fulfillment of their wishes or advocacies rather than the representation of objective analysis.

Buying During Chaos....

The chart from Forbes magazine shows of the milestones successes and failures of buying when “blood is on the streets”.

According to Forbes’ Neil Weinberg, Bernard Condon and Emily Stewart “JPMorgan's Jamie Dimon may prove to be the latest in a line of investors to turn panic into profits. But it's a risky business….”

Nokia Morph Concept: Nanotech's Impact to Telecoms

Here is Nokia's vision of nanotechnology's impact to the telecom sector... press on link below:

(hat tip: Josh Wolfe)

Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist”

``Experience shows that, if one foresees from far away the designs to be undertaken, one can act with speed when the moment comes to execute them.” -Cardinal Richelieu, 1585-1542

Present developments continue to pose as a nightmare for local stockmarket bulls as the key Philippine benchmark effectively traversed beyond its July lows. The Phisix is down by over 24% from its zenith in October, so by definition, a 20% loss demarcates a crossover into the bear’s territory.

Like in politics, biases shape opinions. For instance, Bulls will insist that a 50% drop is a typical correction while Bears will argue that a 5% drop is sufficient evidence of an unfolding bear market. So in an effort to balance our bias, we will go by the technical definitions of the prevailing market conditions.

The Phisix fell by 4% over the week, and is down by over 7% in two consecutive weeks for an accrued year-to-date loss of a harrowing 19.74%. Ouch!

While it is a temptation to say that the domestic political maelstrom could have had a hand in these marked turnaround in sentiment, evidence suggests that it has been prompted MORE by developments abroad (see Figure 1).

Figure 1 stockcharts.com: Phisix Impacted by Global Activities

Alongside the decline in the Phisix, the Emerging Market index (EEM) is likewise down 20.94% (using the same peak-“present” trough measurement), the Fidelity Southeast Asia Index (FSEA) 31.1% and the Dow Jones Asia ex-Japan 23.8%. Thus, the activities of the Phisix appear to be a mirror image of its contemporaries in both the emerging markets rubric or relative to its neighbors.

The chart similarly shows that the Phisix (main window) closed past its July lows (as shown by the circle) and seems headed for the three year trend line support of somewhere around the 2,600 level. So if one considers the strength of a trend under technical rules (Alexander Elders-Trading for a Living-incidentally the first ‘stock market’ book my mentor asked me to read of which I am a practitioner today),

-The longer the timeframe, the more important the trendline.
-The longer the trendline, the more valid it is.
-The more contacts between prices and the trendline the more valid the line.

…this means that the 3 year secular bull market trendline remains soundly intact-Yes under this premise we are still in a structural long term bullmarket operating under an interim bear market-and is likely a better determinant of the destiny of the Phisix, as well as the maturity of its underlying trend and the validity of its present path.

So it would be important to watch how the long term trendline reacts under today’s circumstances than agonize over present day losses. As Scottish Philosopher Thomas Carlyle once wrote, ``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.”

And if one looks at the trend features in the charts of the other indices, we note of the same patterns; long term upside trends appear to be unblemished (yet).

Market Forecasting And The Required Winning Qualities

Of course we have met a lot of skepticism over our prognosis of a Phisix 10,000 (some even seem to think that I maybe hallucinating) in the same way when we called for a Phisix turnaround in 2002 or of the Peso’s reversal in 2004.

But as a long term trend and market cycle observer of different asset classes, we can emphasize with confidence that a secular bull market does not generally end with only 100-200% gains. You can go to chartsrus.com and look over the long term performances (over 15 years of insight rich perspectives of market cyclicality) of many world equity benchmarks and see of what I am talking about.

Just consider; we spoke about the revival of the mining industry (even published at safehaven.com) way back in 2003 when gold and oil’s was in an incipient renascence stage (oil above $40s and gold just over $300). The mining index was then drifting at historical lows of 1,000 level, where we predicted it to go over 9,000. Yes then we were even ridiculed as some sort of a wacko!

Today oil is over 10 times from its bottom and is on record highs even under inflation adjusted prices and gold is 4 times from its nominal bottom (Both of which will even go higher over the long term because of two words-government intervention).

Nevertheless, the Philippine mining index TOUCHED 9,067.26 last November 9^th (realizing our target) or eight times from its bottom when we made our prediction! Today, hovering at the 7,000 levels, the vitality of the commodity cycle will eventually reflect on state of the mining index which should push this easily to over 10,000 over the long term.

The point is to understand how market cycles evolve or operate as a significant way to reduce risks. In the same manner as comprehending how different cycles such as business, economic, commodity or credit cycles interplay to shape market cycles or vice versa (theory of reflexivity).

Remember we are not here for vanity which is an outright guarantee for prospective losses. We are here to profit from taking risks which also means accepting mistakes relative to gains.

And importantly, we attempt to imbue the winning qualities as defined by the legendary Peter Lynch, ``The list of qualities [an investor should have] includes patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic.”

Equity Outflows Are Global As Risk Aversion Rises

Going back to the present market conditions, it is noteworthy that the common denominator for the recent selling pressures in the abovementioned benchmarks is the net foreign selling.

The degree of foreign selling has even begun to impact currency performances of some Asian countries as the Philippine Peso (-1.7%) to Php 41.54 on $69.5 million of net selling, South Korean Won (-4.2%) to 997.32 and Indonesia Rupiah (-1.6%) to 9,226 to a US dollar (Bloomberg) which could have translated into outflows. Remember net foreign selling does not automatically equate to net foreign outflows. It is when the proceeds of net selling are repatriated abroad where it impacts the currency.

Yet, outflows could reflect the present state of rising risk aversion aside from forced liquidations by institutions caught up in the credit gridlock.

Furthermore, the assumption that the US dollar in a tailspin is gaining adherents for investments in its equity market at the expense of alternative markets is unclear. The theory is that relative values are getting cheaper especially in the browbeaten Financial Industry evidenced by the recent activities or acquisitions of Sovereign Wealth Funds (SWF).

Figure 2: Emergingmarketportfolio.com: Equity Outflows is a Global Phenomenon

According to Michael Sesit of Bloomberg, ``In the past two years, sovereign wealth funds and Chinese financial institutions invested at least $77.2 billion in Western banks and money managers. About $66.6 billion of that was placed in the last three quarters of 2007, accelerated by banks' needs for capital infusions after being battered by the subprime- mortgage crisis and related credit crunch.

``The bigger deals include Government of Singapore Investment Corp.'s $9.7 billion investment in Switzerland's UBS AG, and Singapore-based Temasek Holdings Pte.'s 18 percent stake in Britain's Standard Chartered Plc for $9.2 billion. The Abu Dhabi Investment Authority paid $7.5 billion for a 4.9 percent holding in Citigroup Inc., while Temasek invested $4.4 billion in Merrill Lynch & Co. with an option to buy an additional $600 million of stock. China Investment Corp. bought $5 billion of Morgan Stanley.”

Much of the activities of sovereign wealth funds have moderated following the recent stinging reversals in the market. This suggests that following the initial forays by the SWFs in the deeply afflicted financial world, which seems to be nursing significant losses; these entities appear to have mostly stayed on the sidelines since-except in the mining industry.

Besides, there is scant evidence of rotation within the equity markets, according to amgdata.com as of March 12 (highlight mine),

``Including ETF activity, Equity funds report net cash outflows totaling -$1.430 billion in the week ended 3/12/08 with Domestic funds reporting net inflows of $1.949 billion and Non-domestic funds reporting net outflows of -$3.380 billion;

``Excluding ETF activity, Equity funds report net cash outflows totaling -$2.662 billion with Domestic funds reporting net outflows of -$1.776 billion and Non-domestic funds reporting net outflows totaling -$886 million;

``Exchange Traded (Equity) funds report net inflows of $1.231 billion with the largest flows:

$2.195 Bil to the Sel Sectr SPDRs Finl fund;

$2.01 Bil to the iShares Russell 2000 Index fund;

-$1.567 Bil from the iShares MSCI Emerg Mkt Index fund;

$592 Mil to the PowerShr QQQ fund;

``Excluding ETF activity International funds report net outflows of -$718 million as net outflows are reported in all Emerging and Developed regions except Japan ($9 Mil; 0.53% Assets);

``Excluding ETF activity Taxable Bond funds report net inflows totaling $484 million with the largest inflows going to International & Global Debt Funds ($681 Mil; 0.85% Assets);

``Money Market funds report net cash inflows totaling $9.832 billion as assets in the sector now exceed $3.4 trillion;

``Municipal Bond funds report net cash inflows of $677 million.”

So consistent with Figure 2, from emergingmarketportfolio.com, Global equity markets have generally been seeing a withdrawal of funds with the bulk of the outflows from G3 countries (US, Europe and Japan).

Whereas funds flows appear to concentrate on the Taxable Bond funds, Money Market funds, and Municipal Bonds.

Hence, there is little evidence that the debilitated US dollar has been attracting sufficient investments at the expense of the emerging market class as the Phisix. On the contrary, we see the weak state of the US dollar fostered by the unfolding changes in the monetary conditions as potential attractions to the Phisix as discussed in Monetary Conditions Remain Supportive of Emerging Market Assets.

No Bubble In the PSE, Sectoral Performances Evolves To A Dividend Play

Yet in examining the damage arising from the recent selloffs in the Philippine Stock Exchange, the irony is that instead of a pattern of “weak” linkages with the macro environment, we are seeing somewhat of a mixed message from the market activities shown in Figure 3, except for the dividend yield.

Figure 3: PSE: Sectoral Year-to-Date Performances

In developed countries the real estate and the financial industries have been the most bludgeoned sectors. This again is mostly due to the bubble built around depressed interest rates which allowed the public to speculate on real estate “flipping” funded by securitization of mortgages. Thus, when the bubble burst both sectors are today in anguish.

On the other hand, industries which catered to the US consumers, such as exporters have likewise been most impacted in other countries.

Nevertheless as explained in Global Depression: A Theory Similar To A Horror Movie?, the Philippines have entirely missed out the real estate boom as evidenced by the inconsequential growth of real estate loans relative to total loans.

Boom-busts cycles are usually triggered by negative or low real rates which cultivate on spectacular credit growth which is exacerbated by speculative tendencies by the general public. In short, credit growth spurs speculation and investor irrationality.

Martin Wolf of the Financial Times expounds lucidly (emphasis mine), ``All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit. Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.”

To add, in the aftermath of the Asian Crisis, the Philippines seem to have just segued into an advancing phase in the real estate industry. This suggests that the market clearing stage from the previous excesses has allowed for such recovery. Thus, no significant margins or leverages have been built into the system yet.

Third, it would seem that the region, flushed with huge foreign exchange reserves, is steeped upon policies geared towards an infrastructure development.

Fourth, current developments abroad coupled with the recency bias or the rear view mirror syndrome following the 1997 Asian Crisis is likely to compel local lenders to be conservative with their loan portfolios. The lessons of the past and the ongoing around the world today will likely lead to stricter lending standards. A gradual expansion is likely to be sounder.

Fifth, the firming Peso is likely to repatriate domestic capital stashed overseas aside from attracting foreign investments based on growth potentials.

Finally, the BSP recently decided to hold on to the present level of interest rates despite surging the consumer price index, see my blog Philippine Inflation Rate Surge on Soaring Commodities!.

Basically this deepens the negative real interest yield environment as the rate of consumer price increases are starting to close the gap with even longer term treasury yields.

Negative real rates are not the same as nominal low interest rates regime. Negative real rates deals with the function of money as a store of value, thus the opportunity costs of holding cash.

Once the purchasing power of a currency erodes, people will be prompted to look for alternative “store of values” in the form of hard assets as property (Hong Kong, China, GCCs) or stocks (Zimbabwe), or cars (Venezuela) as previously discussed.

Negative real rates punish savers and encourage the public to go into debt to venture into speculative activities. The ensuing malinvestments are the reason why bubbles exist on the first place. This is precisely what had happened to the US.

So when a monetary policy is directed towards “growth” via suppressed real interest rates this induces for a low or negative real yield environment. Thus, you should expect some assets to go up because people will simply look for an alternative “store of value” as replacement to an eroding purchasing power of a currency.

Essentially, given the above, the Philippines or the Phisix or its domestic financial markets has not been induced into a bubble or near bubble scenario…in fact far from it.

Thus, claims that the Phisix is in a protracted bearish scenario is unjustified unless the world turns into protectionism-which should lead to global depression.

Nevertheless, the property sector has taken the most drubbing down 31% year to date. In contrast, the play on the Philippine economy’s service sector led by the telecoms has been the least impacted (-15% as of Friday). So you have two domestic oriented sectors both showing disparate activities as gauged by the index performance.

In addition the performance of the financial sector (-19.4%) exhibits general market decline when compared to the Phisix (-19.74%), which could be interpreted as having marginal or little exposure to toxic papers and has thus shown minimal impact relative to its global counterparts.

Whereas the mining sector which has remained in stupor has seen an explosion on the prices of its underlying product (we will deal with potential divergences in the future).

Instead, the sectoral performances appear reflect positions according to the industry dividend yields. Since domestic investors have been responsible for shoring up today’s market, they appear to gravitate towards industries with high dividend yields.

Based on January PSE data, the service sector index has a yield of 4.62% (telecoms has 5%) thus, the least loss (-15%). This is followed by financials with a yield of 2.7% (loss 19%), industrials 2.45% (-15%), Mining 2.06% (-15%), Holding 1.5% (-25%) and Property 1.18% (-31%). The Phisix has a yield of 2.5% and the All index 2.73%.

As a caveat, present dividend yields are not sufficient indicators for future dividend yields. Past performance does not guarantee future outcomes.

Measuring Market Sentiment: Issues Traded and Daily Trades

Finally we deal with sentiment.

Figure 4: PSE: Daily Issues Traded

Market internals tell us where sentiment lies. Figure 4 shows that even while number of issues traded daily seem dwindling, it remains above the 2003 levels (upper red horizontal line) which possibly suggest that investors remain bullish but the extent of bullishness has been on a decline.

As we would also note, as the Phisix climbed the bullish ladder from 2003 until mid 2007, the number of issues traded has also painstakingly followed. The investing public’s predisposition is to tap the broader universe of the market once risk appetite is accommodative. Thus, today’s risk aversion has reduced the number of trades but remains elevated relative to the past.

We will raise alarm bells if there is a sudden drop of issues traded, since a paucity of daily traded issues could also reflect a strike by fundamental based buyers (for us, these are the category of buyers that matters most).

Figure 5: PSE: Daily Trades: Measuring Speculative froth

Daily trades are our best measure of speculative lather, as shown in Figure 4.

Daily trades incorporate day traders or scalpers, punters, mid term traders and fundamental buyers. The red vertical line seems to be the median point of daily trades during the 2003 until early 2006 or the germinal phase of our bullmarket.

Imagine the Phisix has more than doubled from less than 1,000 to 2,200 within the said period yet daily trades averaged ONLY by around 3,000-4,000 per day with occasional bouts of trading spurts.

Noticeably, daily trades picked up ONLY at the close of 2005 which coincided with the second round attempt of the Philippine peso to move higher.

This made us construe that the firming peso has drawn local investors into the market where they actively punted (due to higher returns expectations) at the expense of the US dollar holdings…until late 2007.

Could we be seeing the same but on an inverse scale…declining trade but higher US dollar?

Today the daily trades have plummeted to near the 2003-2006 levels which limns of greatly reduced speculations within the Phisix.

This leads us to deduce that once the 3,000 level per day is met, the Phisix could mark a BOTTOMING OUT since fundamental based buyers are likely to dominate the Phisix investing space!

By then, local scalpers and punters would have turned into long investors, possibly shun the market, and remain bottled up until the market recovers.

Bottom line: the Phisix remains on an interim bear market but is certainly not under the spell of a protracted bear curse unless huge political lapses will be committed here or abroad. The Phisix under present conditions is simply evolving out of its long term cycle.

To aptly quote Warren Buffett, ``none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital ... Fear is a foe of the faddist, but the friend of the fundamentalist." (highlight mine)

Claims Of The Peso’s Dutch Disease Is A Symptom Of Political Hysteria

``The basic problem is well known and has been frequently illustrated throughout history. Democracy responds to the mob of voters; and the mob wants bread and circuses – at someone else’s expense, of course.”-Bill Bonner

The famous investor Peter Lynch tells us to use objectivity and common sense in parsing at events. However, when a person gets blinded or fanatically obsessed with a particular theme, example with politics, the underlying biases usually skews their logic to the point of losing common sense.

For example, we read an article where an expert bellyached about the Peso’s rise as a “Dutch Disease” impact to the domestic economy. Unfortunately by definition alone Dutch Disease, which is a “natural resource curse” where rising revenues from natural resource exports negatively affects the manufacturing sector via the transmission channels of currency appreciation, does not even seem to fit the bill (OFW remittance is not a natural resource-it is a human resource). Yet as a refresher, OFW remittances-which account for a substantial 10% of the GDP-does not equal to 100% of the Philippine economy in impact. Why do you think consumer spending in the Philippines continue to expand when purchasing power of the OFWs have shriveled? We discussed this in What Media Didn’t Tell About the Peso.

Besides, the US isn’t the only country which the Philippines deal with. In short, it isn’t ONLY about the Peso-US dollar. In fact as we noted in Is the Philippines Resilient Enough to Withstand A US Recession?, there has been a diminishing trend of exposure to the US which is offset by the growing transactions within the region. This means an objective perspective should be seen through the looking glass of the Peso against the rest of the world or in the context of competition with its contemporaries (emerging markets) or possibly its neighbors.

So using the Dutch Disease as an excuse for blaming policy mismanagement is equivalent to barking at the wrong tree. In fact, as noted in a recent post in my blog, The Cost of Currency Intervention: BSP Recapitalization by Issuing Bonds, our central bank the Bangko Sentral ng Pilipinas (BSP) has reportedly been suffering from heavy losses arising from intensive currency intervention-some Php 62.5 billion-which will require the Bank’s recapitalization by issuance of bonds (translation: taxpayers funding the losses!). Yet our so-called expert is exactly asking for more of these losses to protect certain groups!

As an aside 45 years ++ of peso depreciation did nothing to improve our economy, yet instead of dealing with the roots of the problem they look only at superficial solutions which will penalize the country’s future-the children-by burdening them with undue obligations (increased taxation).

It’s a pity how we use data mining and slippery slope arguments to uphold our political biases, when in truth these experts are aware that such premises are nothing but political bunk.

Figure 6: Yahoo.com: China Yuan to Peso (left) Euro to Peso (right)

True, the Peso has climbed about 18% against the Euro and about 17% against the Chinese Yuan since the Peso’s belated run in 2005 as shown in Figure 2.

But this doesn’t necessarily mean that our manufacturing is shifting entirely to these countries due to currency appreciation impelled loss of competitiveness. As pointed out in Philippine Politics: Systemic Defects of the Pork Barrel Political Economy, the ADB has alluded to our narrow industrial base as one of our economic hurdles, and this has been even when the Peso has been depreciating for 45 years!

Besides, as one can note the Peso has recently lost some meaningful ground against the Yuan and the Euro whose economies seem to have evinced little signs yet of contagion impact from the US slowdown.

So it is recommended to adhere to Cambridge University’s Joan Robinson judicious advice (highlight mine) ``The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists."

TSLF: Total Socialization Of Losses Of The Financials

``The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”-Ludwig Von Mises, Human Action

As anticipated, the US Federal Reserve has undertaken drastic measures aimed at alleviating the present circumstances.

As credit markets remain under constant pressure, benchmark yields have continued to rise seemingly irresponsive to the monetary policy actions. Thus the Federal Reserve has opened another novel program called the Term Securities Lending Facility or TSLF.

The TSLF is supposedly a compliment to the existing Term Auction Facility. This allows financial companies to trade directly with the Fed which would lend up to $200 billion and accept a wider degree of collateral including “non-agency AAA/Aaa-rated private-label residential MBS" or papers impacted by the real estate bust.

The facility also allows for a swap lines arrangement with several central banks as European Central Bank (ECB) and the Swiss National Bank (SNB).

To top it all off, the Fed even invoked a Depression era law to facilitate for extending loans to non banks as Bear Sterns via JP Morgan.

Some argue that repos extended as loans against an eligible collateral do not signify as inflationary since they will be reacquired by the Fed and secondly, they are meant to repair the capital base of the debilitated financial institutions and not utilized for normal operations-where once a normalization takes place the added liquidity is withdrawn.

True enough the repos do not expand the Fed’s liability (base money) under the assumption that the collateral has value in it. However, by accepting papers which markets has refrained to put a price into or by putting a bid on an illiquid paper with unknown value or by acting as market maker of last resort exposes the Fed to credit risks. Insufficient collateral means losses for the Fed.

Yet there are some even calling for a greater degree of Fed exposure to the market risks…by directly buying up affected mortgages or outrightly subsidizing losses of the financial institutions, which means greater socialization or nationalization of losses and increased moral hazard. Thus our revised meaning for the acronym of TSLF: Total Socialization of Losses for the Financials

According to Frankfurt School of Finance & Management Honorary Professor Thorsten Polleit in his very instructive article, Inflation is a Policy that Cannot Last (emphasis mine),

``There are basically three strategies the government can pursue to prevent a contraction of the credit and money supply caused by a breakdown of the banking sector.

``The first strategy is to inject peoples' tax money into banks, thereby socializing (part of) the domestic banking industry. Under the second strategy, the government would simply buy banks' risky assets, thereby making available (what is left of) banks' equity capital for new lending.

``However, it does not take much to see that both strategies might be highly unpopular. In particular, to finance capital injections and/or purchases of banks' risky assets, the government would have to take recourse to tax financing — using either current taxpayer money or, in the case in which the government issues bonds, future taxpayer money.

``However, there is the third strategy available to the government, a much more subtle and very powerful way of redistributing peoples' resources through the hands of the state: increasing inflation by making the central bank buy banks' risky assets. In fact, such a strategy amounts to creating inflation via monetizing banks' risky assets.

``That said, surprise inflation can lower the real interest rate burden on outstanding loans only in the short term — at the expense of creditors. However, as long as the money system is based on a relentless increase in bank credit and money supply, it would take ongoing surprise inflation to lower the real debt burden, but such a monetary policy would ultimately lead to hyperinflation.”

All three strategies appear to be at work today.

Another, the program deals with the asset side of the Fed’s balance sheet. The Fed will be changing the composition of its $873 billion in total assets from around $700+billion in treasuries to mortgages, expanding its market and credit risk.

But since the Fed’s balance sheet is materially smaller compared to emerging markets as China, Brad Setser says that the Fed can expand its balance sheets…

``But what if the Fed changes its mind and decides that it needs to expand the amount of support it offers the market? Well, nothing precludes the Fed from following the lead of emerging market central banks and issuing short-term “sterilization bills” to offset the growth of the assets on its balance sheet.

``As around $900b, the fed’s balance sheet is something like 6-7% of US GDP. With $1600b in foreign assets, the PBoC’s external balance sheet alone is more like 50% of China’s GDP.

``In a world marked by unprecedented central bank intervention, the Fed’s balance sheet is still kind of small.

``Expanding the Fed’s balance sheet dramatically to offset a massive deleveraging of the private financial system – a deleveraging that has been compared to a bank run in reverse, with the banks withdrawing credit from hedge funds and broker dealers in much the same way that households withdraw credit from the banking sector in a bank run – would be a truly radical step.”

Yet inflation seems to be the preferred policy option for the US FED, as we have been saying all along, since that the US is a net debtor financed by foreigners who are likely to be the victims of its monetary policy given the urgency of the situation. Ever heard of a Beggar thy neighbor policy?

From Martin Wolf the Financial Times, ``There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.”

With the radical thrust towards increasing TSLF all these will eventually be reflected in the fate of the US dollar, as Mises prophetically observed.

Ergo, gold, oil, commodities and other hard assets are likely to serve as insurance from devaluing paper assets.