Global Stock Markets: Finally A Reprieve, Ivory Tower Syndrome And Ipse-Dixitism

``Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one” -Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

Finally after 6 weeks consecutive weeks and a dazzling 21.64% of gains, the Philippine benchmark, the Phisix, finally succumbed to a hefty 7.72% “profit taking” streak over the week.

Yeah, cower in fear because the big bad bear is back in picture! But is it?

Figure 1: Global Profit Taking

Anyone looking for a simplified answer should get this…we aren’t alone. See Figure 1

While the domestic losses may have the biggest in Asia, perhaps exacerbated by the uncertainties over the political front or just plain momentum-sentiment based panic, the carnage in the region had been nearly equally as steep. For instance, Vietnam, Thailand, Indonesia, Hong Kong and India suffered losses anywhere in the range of 5%-7%. That has been the rule.

The chart shows how the Dow Jones World, Asia Ex-Japan and Emerging Markets simultaneously turning down.

And again, China has again been the exception with both indices (Shanghai and Shenzhen) gaining nearly an astounding 5%.

But it isn’t China alone this time, the recently concluded longstanding Tamil insurgency problem in Sri Lanka appears to have brought about a stockmarket honeymoon.

The Colombo Index has spiked by nearly 9% this week, and is the first of among Asian markets to have reached the pre-crisis levels and is just off by about 20% from the 2007 high see Figure 2.

Figure 2: Bloomberg: Sri Lanka’s Colombo: Honeymoon

And I am predisposed to think that Asian bourses will follow suit.

Additionally, I’d like to point out that the Sri Lankan Colombo index has defied the tide because of an extraordinary development.

Going further, the scale of the recent losses has extended throughout most of Europe and to the Americas. Nevertheless, it has been a mixed showing for the Middle East and African region.

G-8 Communiqué As Catalyst?

So what has spurred this so-called global profit taking?

Technically speaking, under normal circumstances, no trend goes in a straight line.

Empirically, we have been witnessing excess volatility from a massive liquidity driven environment.

Fundamentally, I am predisposed to view this event, the G-8 meeting in Italy last weekend where leaders spoke about plans (actually blarneys) to unwind rescue program-as having been the main catalyst.

This from the Wall Street Journal (bold highlights mine), ``World financial leaders are starting to examine how they will unwind their emergency spending packages and bank rescues as signs emerge that the economic crisis may have hit bottom.

``Finance ministers from the Group of Eight leading countries on Saturday asked the International Monetary Fund to research strategies to slim budget deficits and reduce government presence in the financial sector, but in a way that wouldn't reignite the crisis.”

Three observations from these meaty statements:

One, governments have engaged in massive scale of emergency programs without the benefit of studying the possible unintended effects of such programs.

Two, along with this is the NO contingent or NO exit plans.

Gadzooks! Governments have been operating on mere BLIND FAITH on the feasibility of mainstream economic models!

And lastly, asking the IMF to “research strategies to slim budget deficits” is downright and strikingly preposterous! It resonates of the addiction by governments on boondoggles (spending binges) without considering the financing or all other aspects for that matter.

Commonsense says that you either need to cut spending or raise revenues! How complex or difficult could that be? And you don’t need the IMF for that. Qué Horror! Maybe the G8 leaders need to bankroll me for a lot cheaper price.

Markets, acting apparently on cue, shuddered from the thought of such exit plans! This goes to show how increasingly dependent our financial markets have become to money printing dynamics.

The Ivory Tower Syndrome?

Yet for some, commonsensical thinking or basic economic reasoning isn’t the preferred view.

Ironically commonsensical thinking has been perceived as tantamount to the Ivory Tower Syndrome.

The comments of Professor James K. Galbraith of the Lyndon B. Johnson School of Public Affairs at the University of Texas relates to its definition, ``I don’t detect any change at all. [Academic economists are] like an ostrich with its head in the sand.”

Experts afflicted with the Ivory Tower Syndrome simply means losing touch with reality.

It’s because these experts mostly live in a theoretical world filled with quant or econometric models, with virtually no hands-on exposure at risking their own money. Nonetheless they survive under the stipend of institutions and by NOT getting their hands dirty. In other words, perspectives of Ivory Tower analysts are most likely to be unrealizable, if not delusional and unworthy to be heeded.

As the global financial markets endured from a meltdown during the last quarter of 2008, we pointed out that some significant signs, such as the emergence of barter trade (which signified as an impasse on trade finance more than an economic problem) and an appearance of a bottoming market in China, defied the “realistic” consensus view that the world would fall apart.

At the heat of the panic we even declared a buy! [see October 12, 2008 The Bullish Case: It’s Blood On The Streets!].

Then, except for a few experts as Warren Buffett, Jeremy Grantham and John Hussman whose outlook we explicitly covered, other prominent value investors joined the contrarian bandwagon as Steve Leuthold, Anthony Bolton, Vanguard’s John Bogle and Rob Arnott we mentioned in The Rise of Value Investors Amidst A Prevailing Fear and Loss Environment. All of these elite savants, along with my humble perspective, challenged the interpretation of reality by the consensus as the imminence of deflationary depression!!!

Further, we even found evidences of a bottom in commodities last November 2, 2008, see More Compelling Evidence For An Inflection Point in Commodities!.

Moreover, as signs of improvements got reinforced, we repeatedly pounded on the table that stock markets and commodity markets will eventually be driven by government printing presses around the world, which has collectively been operating on 24/7 basis.

And instead of getting tied with economic gobbledygook, we focused on the inflation dynamics which in our view should give us a better glimpse of the market’s direction [see November 30, 2008, Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?]

This means that, in contrast again to the consensus, whom has opted to fixate on mainly the economic template, our fundamental area of concern has been to scrutinize on the actions of global political leaders and central bankers with its possible ramifications or impact on the markets and the economy.

Simply stated, we DIDN’T DEAL with esoteric mathematical models or flamboyant statistical artifacts seemingly aimed to mostly impress gullible audiences as employed by most mainstream analysts with their highly flawed models, we simply dealt with plain vanilla economic reasoning.

As Gerard Jackson in Economic commentators still clueless about the recession so aptly put, ``Unfortunately there are no mathematical relationships in economics. This means that economics is qualitative and not quantitive, despite the obvious importance of statistics.”

The point of this rant is not to accept or deny the pejorative imputation of Ivory Tower analyst, since that would be subjective. People can just say anything about anybody, true or untrue. It’s all a matter of consistency or inconsistency between the allegation and the performance.

Importantly, the perception of reality has always been a preconception out of individual biases. Alternatively, this means ``People believe what they need to believe, when they need to believe it”, a favorite quote of mine excerpted from Bill Bonner of the Daily Reckoning fame. Otherwise, this is also known as the confirmation bias-or the proclivity to look for or interpret data which confirms to inherent beliefs.

Ipse Dixit: Fundamental Driven Markets

In the present circumstances what seems to be the predilection of the mainstream?

Since the markets have shown signs of “life”, many have extrapolated current price levels as an attribution to “fundamental” driven market-economy dynamics.

In other words, the George Soros’ reflexivity theory seems to be getting even more entrenched- many now insist that fundamentals matter more than liquidity. Why? Because prices say so!!!

Funny, but 9 months ago or even at the start of the year, we haven’t heard arguments of such genre. Now market actions appear to calcify on the biases of many market observers.

Let us put it this way, since we believe that this episode has been tightly driven by the interlinkages of global liquidity channels, then it is likely that stock market and commodity market performance will be reflective of the state of inflation absorption as well as the degree of monetary inflation across the global economic and financial system.

In other words, inflation is always relative. As Henry Hazlitt in What You Should Know About Inflation [p.130] wrote, ``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

Applied to the current setting, I would deduce that that the stock market and commodity markets have been the secondary recipients of global government spending, central bank lending, direct grants and US Federal Reserve purchases of US sovereigns and mortgage bonds. This has prompted some corners to baptize a moniker for this phenomenon as the bailout bubble, as earlier discussed in Monetary Forces Gaining The Upper Hand Equals The "Bailout Bubble"?.

Whereas circulation credit or bank lending from emerging markets or in Asia or in parts of the US (such as federally insured mortgages) or elsewhere could account for as primary or also secondary channels. The Wall Street Journal gives as this clue, ``Because businesses can't put trillions of new dollars to work in such a short time, the money is finding its way into financial markets.” (bold emphasis mine)

Since markets always operate on the basis of expectations, then a synchronic decline in global markets suggest of four possible causes, outside the technical and sentiment based considerations:

One, markets could probably be discounting a peak in government sponsored programs. Given the addiction of governments as shown by the G-8 news, this isn’t the likely route. Governments have been relishing both the spending spree and the apparent initial favorable effects on the markets.

Two, markets could also be factoring in a culmination in bank lending thru policy induced tightening or a by an aggregate private institutional policy curbs.

This isn’t likely so too. Since the US Federal Reserve has been providing leadership and guidance to global central bankers’ action, then its policy rates could serve as bellwether to the interest rate policy direction of other major central banks see figure 3.

Figure 3: St. Louis Fed: Fed Fund Rates futures

We note that while the Fed rates futures have indeed seen a marginal increase to the upper band of the official Fed Rates, it hasn’t succeeded in breaking out yet.

Three, a combination of both.

Fourth, false negative or also a trial balloon. Here the market may have misread the government actions or communications on the threats to unwind or reverse emergency programs, where the official G-8 communiqué may have been unintentional or intentional, possibly targeted at testing markets response.

While I am not certain on the true state of the markets now, the G-8 pronouncements most probably embodies the fourth variable.

Governments given their ideological underpinnings and the present conditions are unlikely to further discomfit the markets. So any further weaknesses by the stock markets are likely to prompt for “dovish” or market friendly communications from the officialdom.

This brings us back to the revitalized arguments of the ‘fundamentalist’, if markets have been moving based on fundamental factors and not from liquidity transmission channels, then why is it then that global markets continue to act almost uniformly? Why are correlations high among regional markets (except for China and Sri Lanka) or even relative to global markets?

The reaction seen in the global markets hasn’t been seen only on Phisix component issues but also in the internal market actions as seen in the market breadth and in the sectoral performance, of the Philippine Stock Exchange (PSE) see figure 4.

Figure 4: PSE: Sectoral Performance, Fundamentals, Where?

The Banking index (black candle), Service (Gray), Commercial Industrial (pink), Holdings (red), property (blue), All index (maroon) and mining (green) have all been down.

The most recent carnage has almost been in the scale of the climax of the October-November 2008 rout, where advance-decline balance has almost been 1:4 ratio!

Further deterioration of market internals at the same rate as last week would translate to the same tsunami that would sink all ships afloat!

So fundamentals, where?

Focus On Issues That Matter

People are unarguably entitled to their perception of reality. If anybody wants to believe in the “reality” of Santa Claus or Peter Pan and tinkerbell or Superman or a living Elvis, no one will stop them.

Although we are open to exchanges of ideas in the same way markets operate on the exchanges of goods or services based on voluntarism and the availability and expected informational changes, my preference for cerebral stimuli are based on merits and show proofs or evidences and not on Ipse-dixitism or an unsupported assertion.

That’s because to operate on hunches or base intuition is likely to be a very risky endeavor where cognitive biases can function as fatal traps. And this applies not only to the investment sphere but to real life non-investment decision making.

A misdiagnosis that leads to a wrong cure risks worsening of the conditions of a patient possibly by complications. In investments, the same misdiagnosis could translate to heavy losses.

And that’s why we try to avoid dealing with gossip or trivia based market actions. Sensationalism, which connects to the majority, only reinforces cognitive biases. And what usually are deemed as popular issues or causes are frequently flawed or even illusory. For instance, politicians sell free stuffs-health, education, jobs, including bailouts and etc. especially during election seasons. In a world of scarcity, there is no such thing as free lunch. Another, some people equate stocks to horse racing, hence, they get what they deserve.

And by the omission of the sensational, it doesn’t matter if our viewpoints aren’t popular. What matters for us is survivability and feasibility.

Conclusion

Despite the harrowing performance of the Phisix or of global stock markets, which may have been prompted for by market’s realization that the good party days may be cut short perhaps based on the conveyed communication by the G-8 meeting or possibly due to overextended or overheated winning streak, it is highly likely that these setbacks could be temporary.

Governments sensing the latest streak of triumphs aren’t likely to upset the present gains, in spite of pressures applied by certain quarters. The present environment has been ideal for the governments as they benefit from both their spendthrift ways and an ephemeral favorable market condition which illuminates on the vainglories of the fictitious centrally based solutions to national economic problems. Maybe Murphy’s Law applies here: If it ain’t broken, don’t fix it.

If today’s markets have been responding to the expectations of culminating inflationary actions then governments will most likely change tones and revert to dovish themes while simultaneously re-inflating the system. That’s our bet.

Besides mainstream experts adhering to the predominant ideology would constantly use technical jingoism of “output gaps” and “idle resources” to rationalize or justify further money printing activities through-quantitative easing, deficit spending, Zero bound policies, negative real interest rates and etc.

So I’d go against the technical outlook which is in present emitting signals in conflict with the probable effects from government policies. Stock markets could go lower or consolidate but won’t probably retest the old lows.

Finally, what appeals to people is what they like or want to hear, read or see premised on their underlying biases.

Biases are inherent to human nature, as it had been hardwired to us by our ancestors. It has been programmed into our genes. Although, the best way to manage bias is by keeping an open mind.

After all, in the markets, it isn’t about being “right” in terms of convictions, it is essentially about being profitable by adopting the “right” flexible mindset and discipline.

So from our end, if the Ivory Tower syndrome equates to survivability, feasibility and performance, then it’s no shame to be labeled as one.

Unfortunately, the idiom, which means to lose touch with reality, would lose its relevance.

Philippine Peso: Interesting Times Indeed

``There are more borrowers who vote than creditors who vote. This is why democratic politics always favors long-term price inflation.” Gary North, Pushing On A String

We noted how the Peso’s performance has been a riddle, as discussed in Philippine Phisix at 2,500: Monetary Forces Sows Seeds Of Bubble

Figure 5: Danske Emerging Market Briefer: Peso Underperformance

The Philippine Peso has been underperforming its peers both in the Emerging Markets and its neighbors see figure 5 and 6.

Figure 6: Bloomberg: Bloomberg-JP Morgan Asia Dollar Index. AP Dollar Index

The Bloomberg-JP Morgan Asia Dollar Index which tracks 10 of the most actively traded currencies in Asia shows that since March of this year, Asian currencies have mostly been up while the Peso has lagged severely.

Recently, an email supposedly from an anonymous official from the World Bank reportedly said that the Philippine government has been manipulating the Peso to keep it below Php 52 to a US dollar-were it should be.

Of course the allegation was not only spurious and politically slanted, but it had little economic or expertise tacked on the assertion which supposedly emanated from a financial expert.

But if there has been any manipulation, it would be to bring the Peso down, this by expanding government liabilities by virtue of deficit spending.

While the Phisix has seen some improvements in foreign inflows over the past weeks, this hasn’t been extrapolated to the attendant firmness in the Philippine Peso. Yet last week’s carnage accounted for a modest net outflow, so this could add to the onus on the Peso.

Ideology of Policymakers Likely Tilted Towards Interventionism

The incentives aren’t for the Bangko Sentral ng Pilipinas [BSP] to appreciate the Peso; the market fundamentally determines the Peso’s strength.

Instead, it is the mainstream ideology based on a consumption modeled economy which gives the authorities the predisposition to depreciate the currency by intervention.

For instance, increased concerns over a material slowdown of remittance growth which may even post negative (-4%), according to the IMF [Manila Standard], risks weighing on the Philippine economic growth to negative (-1%).

So the BSP, in order to keep the economy from seeking its true levels, will increase the purchasing power of foreign based OFWs at the expense of the residents through higher prices. That’s because mainstream economists fixates on OFW remittances which constitutes only about 11-12% of the GDP and has been assumed to carry the onus of consumption expenditures.

Up to this point, I have yet to see a research which provides estimates on the share of OFW spending (direct and indirect or including the so-called multiplier) to total consumption. All the rest have merely been suppositions (and exaggerations in my view).

The fact that economic growth has materially slowed in the face of still positively growing OFW remittances suggests that manufacturing and agriculture could be a larger weight than the OFW remittances but which the mainstream economists and policymakers tend to ignore.

Deficit Spending For Elections, Mano a Mano

Moreover, pre-election spending by frontloading expenditures to spruce up economic figures going into the election could be another possible angle.

The Philippine Government says it is deeply committed to preserving its fiscal discipline, but expects deficit spending target up to 3.2% of the GDP (Philstar.com). Heck, it is election time and many vested interests are positioning for 2010, so it would be natural to expect an overshoot.

DBS along with ING estimates deficits to hit 4.5% of the GDP (GMAnews.tv). No question here about Philippine deficits. But from this premise they predict bearishness on the Peso.

Hello.

Currencies are basically valued by pairs. If the primary concern for the Philippines has been its fiscal deficits, then relative to the US dollar this should be minor.

The US fiscal deficit is expected to reach 13% of GDP see figure 7!

Figure 7: Heritage Foundation: Exploding US Deficits

Think of it, 13% versus 4.5%, that’s a yawning gap in favor of the Peso!

Ok, the US will be borrowing from its own currency, that’s their privilege. And that’s the added risk premium for the Philippines. But the margin has extremely been one sided. Moreover, the key issue would be sources of funding and not just deficits.

Will the US economy rebound strongly enough to generate revenues to pay for these debts? Will there be enough local and foreign savers to finance these humongous public liabilities? Will official sources to continue to fund US government spending sprees? Or will the US monetize its debts?

Remember it isn’t just new issuance but present rollover financing for maturing debts that needs to be taken into account!

The recent activities in bond market hasn’t been optimistic for foreign buying activities of US treasuries, according to the Wall Street Journal, ``The closely watched figure, excluding transactions that don't occur on an open market, recorded net purchases of $11.2 billion in long-term U.S. securities, after purchases of $55.4 billion in March, according to the monthly Treasury International Capital report, known as TIC.” That’s nearly an 80% drop in foreign buying!

Yet this week, the US treasury will hold another record offering to the tune of $104 billion (CNBC.com). So record upon record issuance will test the limits of the global pool of capital. Losing the ability to raise financing will likely prompt for debt monetization or the US will be faced with the risk of a default.

Moreover, deficits are expected to be still relatively larger than the Philippines even in 2010.

Notwithstanding, the unraveling of the next wave of mortgage resets, other credit woes (credit card, auto loans, Commercial Mortgages, leveraged debts) and deficits from states that would necessitate for Federal bailouts are likely to generate pressures for additional deficit financing.

Hey guys, when looking at the Peso, the US dollar isn’t neutral or fixed. It’s like a tale of the tape of a boxing match, mano a mano.

The Last Barrier Standing

Ok there hasn’t been concrete evidence in terms of declining US dollar reserves (which continues to modestly expand in May) or admission from the BSP of any market intervention. So here we are merely making wishy washy conjectures. Maybe we could try to see the outstanding gold holdings.

But as far as BSP intervention is concerned, there seems to be a stronger incentive for such actions on concerns over the sagging consumer spending from declining remittances of OFWs and from election spending that could weigh down on the Peso. That’s the bearish case.

But the last word on the US dollar from Doug Noland in his latest Credit Bubble Bulletin ``Our foreign Creditors may be content to recycle dollar flows back into Treasuries, but they are thus far in no mood to return to financing our business or household sectors. This may prove a major factor contributing to an altered flow of finance throughout the U.S. economy. It can also be read as a warning that the crucial process of dollar recycling rests increasingly on market perceptions of the soundness of one single market – U.S. Treasuries.” (bold highlight mine)

Remarkably, only a single barrier stands between success and doom. You may call it credibility, but I call it FAITH.

Interesting times indeed.

Lost On Oil: False Reality Or Inflation Dynamics In Play?

This is another evidence on how regulators and the public seems lost on what has been happening in the markets and the real economy.


According to the Economist, ``THE oil market is behaving like a bucking bronco again, and politicians are once more blaming speculators for careening prices. It is difficult to assemble a definitive explanation for the rally: a weak dollar helps oil prices, but evidence for improving supply and demand remains thin. Positions held on NYMEX, the New York commodities exchange, have indeed soared. In 2008 America’s Commodity Futures Trading Commission (CFTC), which regulates NYMEX, examined how the changing positions of hedge funds affect prices. It found correlation, not causation, but its investigations were hampered by the fact that it could not examine intra-day trades. Nor could it monitor certain derivatives, such as those traded via London’s InterContinental Exchange (ICE), in which Wall Street dealers are particularly prominent. But in a sign of things to come in the oil market, on June 12th the CFTC said it had launched a public investigation to see whether the biggest natural-gas contract traded on ICE was moving prices around in the more regulated futures markets." (bold highlight mine)

Essentially regulators as much as the mainstream can't find sufficient answers to the conundrum of rising oil prices and weak fundamentals.

Instinctively, regulators always blame such predicament on speculators, when in the contrary, "speculation" has signified as direct responses to the policies imposed.

We have been saying repeatedly that this has been mostly monetary forces dominating both the financial markets and the real economy or inflationary dynamics in motion.

As we earlier quoted Ludwig von Mises in his Stabilization of the Monetary Unit? From the Viewpoint of Theory, at an earlier post, Our Mises Moment Answers Mainstream’s Conundrum of Market-Fundamental Disconnect

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.”

All these constitute an evolving process known "demonetization". Where sooner or later a seemingly "benign" environment may turn into mayhem, if the inflationary process isn't halted.

And additional regulations won't be enough to curtail this process as the public has virtually been responding only to inflationary policies being effected.

Chart: Global Food Price Inflation

Inflation's impact is always relative. And it can be seen in food prices across different nations.


According to the Economist,

``CHANGES in global food prices are affecting some countries much more than others. Despite a big fall from peaks in 2008, food-price inflation remains high in places such as Kenya and Russia. In China, however, falling international commodity prices have been passed on to consumers faster. The price of food, as measured by its component in China's consumer-price index, rose by more than 20% in 2007 but fell by 1.9% in 2008 and by a further 1.3% in the past three months alone."

Of course, there are also many factors that gives rise to these disparities, aside from monetary and fiscal policies (taxes, tariffs, subsidies, etc...), there are considerations of the conditions of infrastructure, capital structure, logistics/distribution, markets, arable lands, water, soil fertility, technology, productivity, economic structure and etc.

Our concern is given the present "benign state of inflation", some developing countries have already been experiencing high food prices, what more if inflation gets a deeper traction globally? Could this be an ominous sign of food crisis perhaps?

Scientists And Mathematicians On Banknotes

Here is an interesting collection of global banknotes.

They aren't printed on with political leaders but with famous scientists and mathematicians.

Below are some of the samples...


You can see the rest of the collection on the website of Physicist Jacob Lewis Bourjaily.

Paul Kedrosky has this observation, ``Interestingly, despite the U.S. arguably being the foremost country in the world in advancing modern science, no 20th century U.S. scientist is represented on these notes. With the exceptions of Franklin and Jefferson, who were polymaths and politicians too, the U.S. is entirely absent from this collection of scientists on banknotes. There is no Crick, Watson, Fleming, Goddard, Salk, Turing, etc."

A China Bubble?

Has China's incredible defiance of the financial crisis been a bubble?

For some analysts the answer is yes.

Here is Bloomberg's Chart of the day, ``Rallies in commodity prices and mining-company shares stem from a “bubble of belief” in China’s economy that is likely to burst, according to Albert Edwards, a strategist at Societe Generale.

``“I believe we will look back on the Chinese economic miracle as the sickest joke yet played on investors,” Edwards wrote yesterday in a report. To support his argument, he cited falling earnings at the country’s industrial companies.

``The CHART OF THE DAY shows year-over-year percentage changes in profits, as compiled by China’s National Bureau of Statistics. The chart combines monthly data from 2005 and 2006 with a quarterly index, started in 2007, that tracks companies in 22 provinces. This quarter’s report is set for June 26.

``Commodity prices climbed 21 percent this year through yesterday, according to the UBS Bloomberg Constant Maturity Commodity Index. Mining stocks paced a 23 percent gain in the MSCI World Materials Index, the year’s top performer among 10 industry groups in the MSCI World Index.

``While the Chinese economy expanded 6.1 percent in the first quarter from a year earlier, Edwards wrote that he was skeptical about its ability to sustain that level of growth during a global recession."

“The bullish group-think on China is just as vulnerable to massive disappointment as any other extreme example of bubble- nonsense I have seen over the last two decades,” his report said. “The fall to earth will be equally as shocking.”

The Shanghai index has been up about 66% from the 2008 troughs.

Chart from World Bank

Our view is that while China's booming economy may have evinced some signs of bubble blowing, as shown by the exploding loan growth, mostly in response to government fiscal and monetary actions, it seems unclear that this bubble will implode anytime soon.

So far China's boom has clearly been engineered by government stimulus as shown by the massive growth in government Fixed Asset investments (FAI)...

And the apparent impact has been a resilience in consumer income and spending as shown above.

The idea of a "China bubble" shouldn't be confined only to China, because China has the capacity to absorb more debt considering its high savings and low systemic leverage.

Instead "bubble dynamics" should be seen applied to generally most OECD and key emerging nations as governments collectively had been printing money to get around this crisis.

Chart from Danske

Moreover, the recent commodity boom isn't largely tied to an "economic boom" but rather China's tacit desire to diversify away its US dollar holdings from US government's attempt to inflate away its overindebtedness problem.

Bubbles, which actually represent business cycles shaped by government policies, can last longer than what mainstream experts project.

Besides, governments around the world, considering their adopted economic ideology, will probably continue to pump money to sustain price levels.

We see the next bubble to be a government debt bubble which would probably be vented mainly on the currency markets.

Remember, it seems more than just traditional "demand and supply" at work. It appears that "inflation dynamics" have been growing a far larger influence in today's world.

Graphic: 7 (+1) Ingredients That Led To Today's Financial Crisis

Interesting graphic on the anatomy of today's crisis [hat tip: Barry Ritholtz/wallstats.com]

I'd like to add an 8th variable; policies and regulations that has skewed the public's incentives towards the bubble.

As Tyler Cowen wrote in the New York Times, ``And legislation that has been on the books for years — like the Home Mortgage Disclosure Act and the Community Reinvestment Act — helped to encourage the proliferation of high-risk mortgage loans. Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

``In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong."

To add, this from Arnold Kling of Econlib, ``Our high corporate tax rate, along with the deductibility of interest for corporations, encourages corporations to look for ways to minimize equity financing. For individuals, government-subsidized mortgages and the tax deductibility of mortgage interest help to encourage over-leveraging."

INO's Adam Hewison On The S&P 500: Market Tenor Has Changed, Emphasis On The Negative

INO.com's Adam Hewison conducts a lucid technical analysis presentation of the US benchmark the S&P 500.

Click on the chart below to direct you to INO's webpage.

I hope technicians out there will enjoy this.

The Best Global Retail Opportunities Are To Be Found In Emerging Markets

A.T. Kearney in a recent report says that retail opportunities are to be found in Emerging Markets. There are three aspects why this would be so; namely, lower rents, the growth expansion towards tier 2 cities and lastly acquisition.

The first is lower rents.

Here we quote the Wall Street Journal,

``According to the consulting group, there’s room for growth in places such as Dubai, where the housing bust has left many a glass tower empty and is helping to ease rental prices. Builders are starting to lower the price of retail space in Eastern Europe as well.

``Cheaper rents in the emerging markets are good news because that’s where the economy is expected to rebound this year. While GDP continues to sink in the U.S. and Europe, it is forecast to rise in many developing countries on the back of expected 5.2% average growth in nations like Brazil, Russia, India and China — the so-called BRIC economies. And with the economy back in positive territory, the developing world’s growing middle class should soon be ready to open its wallet again."

The second aspect could be found in the tier 2 cities or cities which could benefit from the expanding logistical networks arising from the congestion or saturation of tier 1 or major cities.

The retail cycle as illustrated by AT Kearney

Again the same Wall Street Journal article urges western companies to take advantage of this time restrained opportunities, ``Western retailers should be quick to pop their heads in the emerging part of the world, A.T. Kearney warns. The window of opportunity to seize share in an emerging market usually lasts around seven to 10 years, “when real estate is still inexpensive, logistics networks are beginning to improve, consumers are beginning to spend their disposable income on branded products and there aren’t a lot of competitors around.”

The last would be acquisition opportunities. The recent crisis has exposed some emerging market retailers to deep financing problems, yet these companies carry valuations that are attractively low.
So acquisitions could come by with inherent advantages of "key distributions, consumer insights and premium real estate footprints."

Unfortunately, the Philippines ranks 25th, nearly at the bottom of the 30 emerging markets incorporated in the study.

Has World Trade Been Picking Up?

Yes, according to Businessweek.

Chart from Panjiva

This from Businessweek's Joe Weber,

``In yet another sign that some key players are acting as if recession is on the run, more offshore manufacturers are shipping goods into the consumer-driven U.S. market, global-trade tracker Panjiva reports. The May trade data mark the third consecutive monthly rise in the number of shippers moving such goods, the first such Trifecta since the firm began following this metric in July 2007.

``“Increasingly, it feels that the worst is behind us,” says Josh Green, chief executive officer of the trade-tracking firm. Waxing cautious, however, he adds “Still, we have a long way to get back to the pre-crisis level of global trade.”

``Nonetheless, the data, released June 16, suggest that global trade has hit bottom and is taking the first steps toward recovery. Some 131,688 suppliers were active in May, up 2% from the number in April. The rises in shipper tallies give the Panjiva analysts heart, since such totals have been sliding since at least July 2007, when they counted 161,905 shippers moving goods into the U.S.

``The analysts point to other barometers of improvement, too. The percentage of significant manufacturers on a watch list – those in danger of going out of business – dropped a percentage point to 30% in May, for instance. This marked the first such decline since Panjiva started tracking this metric last September."

Read the rest here. (Hat tip: Mark Perry)

The recent rise in the Baltic Dry Index, commodities (CRB) and oil could be partly be due to this.

Nevertheless, our take has been that the collapse in global trade was mainly a consequence of the seizure "shock" in the US banking system which virtually shackled global trade flows by constricting access to financing.

Although the paradigm which underpinned the past boom won't be revived, present signs of recovery could have been due to the replenishment of inventory destocking.

As for how sustainable this would be remains to be seen.

Iran's Ongoing Election Drama in Pictures, George Friedman's Take and Social Networks

Boston.com has a fantastic deck of pictures covering the ongoing bitterly disputed post-presidential elections drama.

See first part here Iran's Presidential Election

second part here Iran's Disputed Elections

And third part here Iran's Continued Election Turmoil

Meanwhile, here is Stratfor's George Friedman take on the elections...


Finally, we learned how instrumental or pivotal social networks have been contributing to this unfolding spectacle.

This from the Reuters,

``The U.S. State Department said on Tuesday it had contacted the social networking service Twitter to urge it to delay a planned upgrade that would have cut daytime service to Iranians who are disputing their election.

``Confirmation that the U.S. government had contacted Twitter came as the Obama administration sought to avoid suggestions it was meddling in Iran's internal affairs as the Islamic Republic battled to control deadly street protests over the election result.

``Twitter and Facebook have been used as a tool by many young people to coordinate protests over the election's outcome." (bold highlight mine)

Jessica Hagy's Indexed: Teachers Can Save The Economy"

A simple but striking message from Jessica Hagy on how "Teachers Can Save The Economy"

Monetary Forces Gaining The Upper Hand Equals The "Bailout Bubble"?

It's been our repeated assertion that monetary forces have been dominating the financial markets and this has been generating some spillover effects to the real economy from which the mainstream labels as "greenshoots".

An article from the Wall Street Journal seems to recognize this phenomenon, which they brand as the "BAILOUT Bubble".

chart from the WSJ

Quoting the WSJ, (bold emphasis mine)

``But governments around the world are pumping money into the economy at a frenetic pace. Because businesses can't put trillions of new dollars to work in such a short time, the money is finding its way into financial markets. Some investors have begun speaking of a "bailout bubble" being created in certain markets, and about a "melt-up" in demand fueled by the growing supply of money."

``"All that money that was printed had to go somewhere," says Joachim Fels, co-head of global economics at Morgan Stanley. "It has been pushing up commodity prices and stock prices, starting in emerging markets and then pushing over into developed markets."

``The U.S. government alone has allocated $11.4 trillion to direct and indirect stimulus in the past two years, of which about $2.4 trillion has been spent, according to an estimate by Daniel Clifton, head of policy research at New York's Strategas Research Partners. Most of the money has been pushed out in the past year.

``The money is gushing from direct grants, central-bank lending, tax breaks, guarantees and other items. China has announced plans for $600 billion in direct stimulus spending; Russia, $290 billion; Britain, $147 billion; and Japan, $155 billion, according to Strategas. Those countries and others are spending trillions more indirectly.

``"It is quite easily the biggest combined fiscal stimulus the world has ever seen in modern times," says Jim O'Neill, chief economist at Goldman Sachs. "That liquidity will impact anything that is sensitive to it, ranging from short-term fixed-income securities through stock prices through property prices and into people's personal wealth."

We might add that government direct spending (e.g. infrastructure and etc.), federally insured mortgages, and Federal Reserve purchases of US treasuries and mortgage bonds from overseas investors and central banks as possible alternative channels from which bailout money has been reallocating of risk.

Dr. John Hussman recently wrote taking a different approach, he says, ``the proper way to think of all of these bailouts and stock issues is not that new purchasing power is being created, but that ownership of existing assets and liabilities has changed in a way that reallocates risk from the private sector to the government. There is not a bunch of money "looking for a home." The overall effect of the bailouts has been to put Treasury securities and temporary bank reserves in the hands of the financial companies, in return for preferred stock and temporary repos of commercial mortgage backed securities. Let those corporate securities fail however, and that's when we have a real money creation problem, because the government will have created liabilities that it cannot buy back in using the assets it took in when it created them. That's a huge risk here."

Nevertheless, the WSJ article goes on to say that this isn't likely going to end well.

``The growing liquidity also is creating serious policy challenges. Senior economists, including Federal Reserve Chairman Ben Bernanke in congressional testimony on June 3, have begun warning that the government can't keep piling up debt at current rates without creating severe financial problems.

``In coming years, officials will need to raise taxes, cut spending, or both to mop up the ocean of liquidity they have created. That process could weigh on growth and stifle the market boom...

``If the government fails to mop up the money, the consequence could be even worse: inflation and a collapsing dollar."

``Past liquidity-driven booms haven't ended well. In 1998, the Federal Reserve injected cash into the economy to rescue teetering bond markets. The unintended outcome: Technology stocks soared and then cratered. After the government turned on the spigot in 2001 to stave off deflation, residential real estate surged and then collapsed."

So whether this is about money flows or reallocation of risks or stages of inflationary cycle (the latter view is where I lean on), the end game isn't going to be anywhere tranquil.

Policymakers are only deceiving themselves to believe that surges in stocks and commodities signify as "recovery" or "signs of stabilization". They perhaps know deep down inside that a "policy of bailouts will only increase their number", which means persistent expanded inflation to keep prices at present levels. And their supporters, nonetheless, advocate this.

Yet all these are unsustainable.

Nicolas Kristof: Why The War On Drugs Is A Failure

The war on drugs seems to have turned out like the US prohibition of alcohol or the "Volstead Act" in the 1920s.

The consequence of which was not only a failure of regulation to achieve its goal, but that it had created more problems than what it was meant to achieve, particularly black market for bootleg liquors, gangsters, mass violence, mass murder and etc.

Obviously the end result was that the Act was lifted in 1933.

Now, New York Times' high profile columnist Nicolas Kristof makes a pitch on why the same legal efforts to purge drug use seems to achieve parallel unintended consequences akin to the defunct Volstead Act.

This excerpt from his excellent article "Drugs Won The War" (all bold emphasis mine)

``This year marks the 40th anniversary of President Richard Nixon’s start of the war on drugs, and it now appears that drugs have won.

``“We’ve spent a trillion dollars prosecuting the war on drugs,” Norm Stamper, a former police chief of Seattle, told me. “What do we have to show for it? Drugs are more readily available, at lower prices and higher levels of potency. It’s a dismal failure.”

``For that reason, he favors legalization of drugs, perhaps by the equivalent of state liquor stores or registered pharmacists. Other experts favor keeping drug production and sales illegal but decriminalizing possession, as some foreign countries have done.

``Here in the United States, four decades of drug war have had three consequences:

``First, we have vastly increased the proportion of our population in prisons. The United States now incarcerates people at a rate nearly five times the world average. In part, that’s because the number of people in prison for drug offenses rose roughly from 41,000 in 1980 to 500,000 today. Until the war on drugs, our incarceration rate was roughly the same as that of other countries.

Second, we have empowered criminals at home and terrorists abroad. One reason many prominent economists have favored easing drug laws is that interdiction raises prices, which increases profit margins for everyone, from the Latin drug cartels to the Taliban. Former presidents of Mexico, Brazil and Colombia this year jointly implored the United States to adopt a new approach to narcotics, based on the public health campaign against tobacco. [see below-BTe]

``Third, we have squandered resources. Jeffrey Miron, a Harvard economist, found that federal, state and local governments spend $44.1 billion annually enforcing drug prohibitions. We spend seven times as much on drug interdiction, policing and imprisonment as on treatment. (Of people with drug problems in state prisons, only 14 percent get treatment.)...

``It’s now broadly acknowledged that the drug war approach has failed. President Obama’s new drug czar, Gil Kerlikowske, told the Wall Street Journal that he wants to banish the war on drugs phraseology, while shifting more toward treatment over imprisonment.

``The stakes are huge, the uncertainties great, and there’s a genuine risk that liberalizing drug laws might lead to an increase in use and in addiction. But the evidence suggests that such a risk is small. After all, cocaine was used at only one-fifth of current levels when it was legal in the United States before 1914. And those states that have decriminalized marijuana possession have not seen surging consumption."

Read the rest here

The 3 former presidents of Latin American Nations mentioned above by Mr. Kristoff are Mr. Fernando Cardoso the former president of Brazil, Mr. Cesar Gaviria former president of Colombia and Mr. Ernesto Zedillo former president of Mexico, whom also made the same argument early this year at the Wall Street Journal.

``The war on drugs has failed. And it's high time to replace an ineffective strategy with more humane and efficient drug policies. This is the central message of the report by the Latin American Commission on Drugs and Democracy we presented to the public recently in Rio de Janeiro.

``Prohibitionist policies based on eradication, interdiction and criminalization of consumption simply haven't worked. Violence and the organized crime associated with the narcotics trade remain critical problems in our countries. Latin America remains the world's largest exporter of cocaine and cannabis, and is fast becoming a major supplier of opium and heroin. Today, we are further than ever from the goal of eradicating drugs.

Read the rest here

Be reminded that laws or regulations no matter how noble its goal, can have unintended or long term "unseen" consequences.

And at the end of the day, regulations fall into the taxonomy of economics. The success of which would be determined by the tradeoffs between long term costs and benefits.

Mark Mobius: The Most Important Lesson Is To Be Patient

From Franklin Templeton's monthly Emerging Markets Review

Feature of the Month: Q&A on Emerging Markets with Mark Mobius, Executive Chairman, Templeton Asset Management Ltd. (red highlight mine)

Emerging markets have been outperforming thus far in 2009, do you think this trend will continue for the rest of the year?

Although we are optimistic about the opportunities for upside potential, it is important to realize the volatility is still with us and will be with us for some time. This means that there will be periods when the markets go down as well as periods when they go up. We should therefore take advantage of dips in the markets to buy stocks cheaply, paying attention to valuations and long-term earnings growth prospects in order to avoid buying or holding expensive stocks. We continue to find good value in markets like China, Thailand, Brazil, Mexico, Turkey and South Africa.

What sectors are you looking at now?

Commodity stocks look attractive because many of them have declined below their intrinsic value and we expect the global demand for commodities to continue its long-term growth. Consumer stocks also look attractive. With rising per capita income and strong demand for consumer and other goods, the earnings growth outlook for these stocks is positive.

Will the global equity market retest the low point in March?

There is always the possibility of this happening and it could be triggered by something totally unexpected, such as war breaking out on the Korean peninsula or a massive global flu pandemic. As I have said, markets will continue to be volatile as global economies remain fragile and we should see rises and falls in the months ahead.

Which country do you expect to be the best performer from the BRIC markets?

That would be impossible to say at this time but we think China has a good chance of achieving that goal. Of course, I'm talking about measuring that move from the beginning of this year. Russia also looks very undervalued.

In view of China’s strong market performance, would you say that it’s in a bull market?

You can see that it is a bull market since the increase has been so dramatic but it would be difficult to call it a sustainable bull market in view of its very sharp rise. I still feel that we will face volatility and there will be corrections along the say. We, do however, expect China to continue to take lead the global market recovery.

Will the Chinese government propose another stimulus package in 2009? Why?

That all depends on the success of the measures already in place. They clearly have the resources to do this again. We should expect them to act if current measures and programs do not give the desired results.

You mentioned in October that Russia's cheap stocks were an once-in-a-lifetime opportunity. Since then, the RTS Index in Russia fell a bit more to 498, then subsequently doubled this year. After that great performance, are stocks still a good value, or is it time to take a breather?

Russian stocks still look cheap. Yes, they have risen dramatically from their low point but they are still a long way from their previous high. Of course, the P/E has risen this year but Russian stocks, as represented by the MSCI Russia index, are still trading at a single-digit P/E of 6.8x as of end-May, 2009, an increase from an even lower 3.4x as of end-December 2008.

Do the economic problems within Russia--unemployment rising to 10 percent, inflation at 13 percent, and possible GDP contraction of 6 percent--undermine the investment case for the country right now?

These factors will have a short-term impact on the market, but we always evaluate companies on a long-term basis – taking a five-year view. Thus, we are in fact able to benefit from buying stocks at cheaper prices now.

Do you see any parallels between the market crash in Russia of 1998 and the one over the last year? Is there fear focused on this market that leads to sharper crashes than elsewhere? Did you learn anything in 1998 about Russia that helped you navigate this crisis?

No, because Russia and most other markets are in a much stronger position, financially and economically, than they were in 1998. Russia built up strong foreign exchange reserves and trade surplus which has enabled it to withstand external shocks to its economy.

The Russian market was also affected by the correction in commodity prices due to its high exports of oil and other commodities, as opposed to any extraordinary fear focused on this market. However, we maintain the view that commodity prices will continue to increase in the long-term due to greater demand from emerging markets and a relatively inelastic supply. This shall, thus, benefit Russia in the future.

The most important lesson we’ve learnt from 1998 or any other crisis is that markets always recover - it’s just a matter of time. Thus, one should always maintain a long-term and patient view to investing.

Lastly, you have been investing in the emerging markets for the last 4 decades. Being an expert in investing in emerging markets, do you have any advice to share with investors during the recent market situation?

It is very important for investors to remember some key principles: (1) diversify - it is important to diversify in order to minimize risk - this is why investing in a diversified mutual fund is best for investors, (2) look globally - no country has a monopoly on good opportunities so you must search globally - this is why we have global emerging market funds, (3) be patient - don't expect to obtain quick gains - the long term investors do best, (4) don't invest unless you understand the investment your are making - understanding will strengthen your confidence and enable you to make long term investments.

Graphic on Iran's Basic Political Structure

Iran recently held its presidential elections which turned out to be a tumultuous bitterly contested exercise.

Anyway, below is a flowchart of Iran's political system.

(hat tip: Paul Kedrosky)