The Asian-Emerging Market Momentous Historical Bubble?

``When a long-term trend loses momentum, short-term volatility tends to rise, it is easy to see why that should be so: the trend-following crowd is disoriented.”- George Soros

Excess volatility is the name of today’s game.

Global equity markets have been in a wild rollercoaster ride of late.

While US and European markets continue to sag following last week’s sharp decline, many of key Asian markets rallied hard recovering substantial segments of losses from the previous week.

So we seem to be witnessing another round of divergences at play, see figure 2.

Figure 2: stockcharts.com: Asia and EM stocks OUTPERFORM anew

The Dow Jones Asian Index which includes Japan appears to be testing for a new high, along with the less robust Emerging Market index (EEM) and the US S&P 500 (SPX). The weakest link seems to be European Stocks (STOXX).

Momentous Historical Bubble, Elixir Trade Model

The same friend, who commented earlier about the temptations of falling captive to gravity pulled “knives” in a bearmarket, likewise remarked of his friend who earlier paid for a series of monthly subscriptions to a local analyst, who is on the business of issuing regular technical charting outlook.

His friend came to realize that chart reading can be variable, vacillating and couldn’t be relied on, and hence, after a few months desisted from extending this “privilege”.

It’s simply amazing how people can be so captivated or bedazzled by the allure of short horizon Holy Grail type of market approaches, such that they have been shelling out substantial amounts to pay for guidance that dwell mostly on momentum driven or support-resistance trades or simply confirming biases of market participants through the technical picture. It seems like an incredible business model, I might add.

Yes, although this has been an opportunity cost for me in terms of the newsletter business paradigm, nonetheless, we’d rather stick by our principles to deal with prudent investing.

So aside from illustrating the possible dynamics of how the retail market works and how the some local subscription model business had profited immensely from the need for elixir based trades, the point of this article is to prove that today’s market can truly confound mechanical technicians or even macroeconomic fundamentalists.

Why is this so?

To put on our Ivory Tower thinking cap, we quote Prof. Steve Horwitz in The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008, ``The Austrian approach to macroeconomics can already be seen as being fundamentally microeconomic. What matters for growth is the degree to which microeconomic intertemporal coordination is achieved by producers using price signals, especially the interest rate, to coordinate their production plans with the preferences of consumers. However, this coordination process can be undermined through economy-wide events that might well be called “macroeconomic.” In particular, the very universality of money that makes possible the coordination that characterizes the market process can also be the source of severe discoordination. If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result. When money is in excess or deficient supply, interest rates lose their connection to people’s underlying time preferences and individual prices become less accurate reflectors of the underlying variables of tastes, technology, and resources. Monetary disequilibria undermine the communicative functions of prices and interest rates and hamper the learning processes that comprise the market.” (emphasis added)

In short, too much of monetary inflation distorts the function of price signals which essentially increases speculative activities, massively misallocates capital away from consumer preferences and engenders excessive market volatility.

And if we go by the market savant George Soros’ perspective of the market, ``Many momentous historical developments occur without the participants fully realizing what is happening.”

Incidentally we’ll be quoting much of George Soros’ market wisdom for this article.

And such “momentous historical development” could essentially be a seminal formation of the next bubble, in Asia and in Emerging Markets, see figure 3.

Figure 3 US Global Investors: Excess Liquidity Drives Up Asian Markets

According to the US Global Funds, ``U.S. Federal Reserve’s reluctance to withdraw from quantitative easing programs should bode well for Asian asset prices going forward. The past 25 years suggest that when money supply expansion outpaced GDP growth in the U.S., excess liquidity would typically drive equity prices higher the following two years in emerging Asia.” (bold emphasis added)

Oops, let me repeat… “excess liquidity would typically drive equity prices higher the following two years in emerging Asia”!!!

We are hardly into the first year of liquidity driven boom, which subsequently means more upside ahead.

So while markets can go anywhere over the interim, and that infirmities may follow the recent strength due to numerous variables: such as technical corrective patterns in the US [see INO's Adam Hewison On The S&P 500: Market Tenor Has Changed, Emphasis On The Negative-this is assuming the Phisix will track the US] or in the Phisix itself, seasonality weakness (July to September statistically is the weakest quarter for stocks), volatility brought about by next wave of US mortgage resets [see US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!] and plain vanilla momentum- the sheer might of the combined stimulus package from Emerging Markets, (see figure 4) aside from those applied in OECD economies, could translate to an awesome impact for the markets in Asia and the Emerging markets to behold.

Figure 4: Deutsche Bank: EM-Anti Crisis Measures

The Philippines relative to other Emerging Market contemporaries seems hardly one of the most lavish spenders for government stimulus. Think about it, if deficit spending equates to weak currencies as discussed last week in Philippine Peso: Interesting Times Indeed, then it follows that China, Russia, Hong Kong, Brazil, South Africa, Vietnam, Thailand would all have weak currencies relative to the US dollar due to their larger deficit spending. Unfortunately this hasn’t been the case.

Nonetheless, ``Asian and Latin American banks, notes the Deutsche Bank, “seem to have learnt from their past crisis episodes. In general, they have restricted foreign-currency exposures and funded credit expansion with domestic deposits. Thus, most banking systems have suffered from tighter liquidity conditions but only a few have needed recapitalisation (Korea, India and Hong Kong). On the fiscal side, government packages seek to neutralise the effect of shrinking domestic demand as well as supporting local companies unable to roll over their foreign debt obligations.” (emphasis added)

As we have long been saying, an unimpaired banking system in the region and in Emerging markets coupled with substantial savings has the potential to take up the credit slack from the bubble bust plagued OECD economies to shore up domestic demand. And this alone is a massive force to reckon with.

Another empirical example, just this week, it’s like I received numerous calls or text messages from different banks on daily basis, offering me bank loans mostly based on the unused portion of my credit cards. I’d assume that this applies to their entire customer base.

As the Deutsche Bank concludes, ``The crisis is not over yet and we do not rule out additional bumps in the road. However, it is fair to state that in a more globalised world characterised by stronger linkages among economies, emerging markets are proving to be better prepared to face external shocks than in the past.”

Well “proving to be better prepared to face external shocks than in the past”, can be interpreted in a relative sense and applicable only when compared today against the recent past.

But if the bubble cycle is brewing from within, then such conclusion won’t hold when the bubble pops.

Inflation Analytics Over Technical And Fundamental Approach

Remember in a highly globalized world, the transmission mechanism from inflationary policies could be very substantial and has far reaching consequences.

And that is why in spite of the most recent global meltdown, out of the 77 countries monitored by Bespoke Investments [see our earlier article Inflation or Deflation? The Global Perspective], 59 nations experienced consumer price inflation against 14 nations that saw consumer price declines (consumer price deflation) while 4 nations saw flat CPI rates. This translates to a ratio of 4:1 in favor of inflation with an average inflation rate at 4%! And that includes the peak of the meltdown!

For all the claptrap about the global deflation bogeyman, this should have disproved such an assertion.

Figure 5: Danske Weekly Focus: The tide is turning

And the credit boom appears to be filtering into the real economy as Industrial production in key Asian regions has sharply picked up, shown in Figure 5.

Nonetheless, aside from disoriented chart technicians, we also have conflicting predictions from multilateral agencies.

The readjusted outlooks saw the World Bank projecting a downgrade, whereas the IMF has raised its forecasts for world economic growth. On the other hand, OECD has joined IMF to forecast a modest increase in global growth.

2 out of 3 doesn’t mean that the majority is right.

Nonetheless, to put this anew in the context of George Soros’ reflexivity, `` The greater the uncertainty, the more people are influenced by the market trends; and the greater the influence of trend following speculation, the more uncertain the situation becomes.”

So yes, more reflexive actions are unfolding in the marketplace. As the market prices continue to move higher, the public will likely interpret market performance as indicative of the real economy.

Again from Mr. Soros, ``People are groping to anticipate the future with the help of whatever guideposts they can establish. The outcome tends to diverge from expectations, leading to constantly changing expectations and constantly changing outcomes. The process is reflexive.”

So not only do we speak of excess liquidity, but of excess liquidity translated into a secular weak dollar trend see Figure 6.

Figure 6: US Global Investors: Inverse Correlation Weak US Dollar, Strong Asian Markets vice versa

The weak dollar has had a strong inverse correlation with the performance of Asian stock markets, where a strong US dollar trend translates to weak equity markets and weak US dollar equals strong Asian markets trends.

With the US dollar trade weighted index expected to suffer from a secular decline as a consequence to its massive deficit spending, the continuity of these correlation suggests of the persistence of a revitalized or reenergized Asian markets.

Moreover, the prospective weaknesses in the respective bubble bust scourged economies combined with the appearances of the “right” and “effective” remedy measures ensures that present policy directions will be sustained.

Proof?

The ECB recently announced that it will be lending a historic €442 billion ($621 billion) over the next 12 months to backstop liquidity within the region.

The US Federal Reserves’ FOMC meeting recently announced that it would be extending most of its liquidity facility programs specifically, the Board of Governors approved an extension to 1 February 2010 of the following: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF) Term Securities Lending Facility (TSLF).

The expiration date for the Term Asset-Backed Securities Loan Facility (TALF) remains set at December 31, 2009. The Term Auction Facility (TAF) does not have a fixed expiration date. In addition, the temporary reciprocal currency arrangements (swap lines) between the Federal Reserve and other central banks have been extended to February 1. (Danske Bank)

The Swiss National Bank conducted a series of intervention in the currency markets last week to keep the Franc from rising amidst a deflationary environment and shrinking economic growth (WSJ).

And this hasn’t been confined to the Swiss Franc, market chatters speculated on possible government interventions in the currency market in the Kiwi (New Zealand Dollar), the Loonie (Canadian Dollar) and the Aussie (Australian Dollar). (Bloomberg)

Moreover, the issuance of the new Won 50,000 banknotes in South Korea, after 35 years (the largest had been Won 10,000), further fueled speculations that the South Korean government could be expecting higher inflation from current policies undertaken (Financial Times).

As you can see, global governments have been conducting mercantilist “race to bottom” policies for their respective currencies to maintain their “export” latitude.

And as Steve Horwitz, echoing the Austrian school perspective, says that, ``If there is something wrong with money, the fact that it touches everything in the economy will ensure that systemic “macroeconomic” problems will result.”

And the continuation of these developments will only compound on the growing risks of a global inflation crisis.

So in my view, globally coordinated policy based programs to ensure excess liquidity through zero bound rates, quantitative easing and intensive stimulus fiscal spending programs, which has been manifested in the steepening of the global yield curve [see Steepening Global Yield Curve Reflects Thriving Bubble Cycle], a floundering US dollar, currency interventions or the implicit currency war, the reflexive market action which has been diffusing into the real economy and rising risk appetites based on credit boom outside the bubble plagued economies- all conspire to pose as more powerful or potent forces to deal with than simply technical or seasonal factors over the next “two years” at least.

Since market timing isn’t likely to be anyone’s expertise especially in the context of short term trades, we’d rather focus on the major trend as defined by George Soros.

The Boom Bust Cycle Of George Soros

This brings us to the boom bust stage cycle as defined by George Soros which we last mentioned in 2006:

1) The unrecognized trend,

2) The beginning of a self-reinforcing process,

3) The successful test,

4) The growing conviction, resulting in a widening divergence between reality and expectations,

5) The flaw in perceptions,

6) The climax and finally

7) A self-reinforcing process in the opposite direction.

In my assessment, present developments are highly indicative of the transition from 1) the unrecognized trend-as manifested by the substantial skepticism over the present market cycle and 2) the beginning of a self-reinforcing process.

In other words, the bubble cycle has much to accomplish yet.

Since this article has been a George Soros quotefest, the last statement belongs to Mr. Soros, ``Economic history is a never-ending series of episodes based on falsehood and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited"

Stranger, Friendlies or My Friend?

Quote of the day from the ever eloquent and adroit marketing guru Seth Godin-from his latest terse but inspiring missive, The difference between strangers and friends.

(bold emphasis added)

``Strangers are justifiably suspicious.

``Friends give you the benefit of the doubt.

``“Friend” is more broadly defined as someone you have a beer with or meet up with to go on a hike. A friend is someone who has interacted with you, or who knows your parents or reads your blog—someone with history. If you’ve made a promise to someone and then kept it, you’re a friend. If you’ve changed someone for the better, you’re a friend as well.

``We market to friends very differently than we market to strangers. We do business differently as well.

``Thanks to social networks and the amplification of stories online, we have far more friends per person than at any other time in human history. Nurturing your friends—protecting them and watching out for them—is an obligation, and it builds an asset at the same time.

``(I want to distinguish friends from 'friendlies', the people you have a digital link to, but no real connection. Friendlies are basically strangers with a thumbnail of their face on your screen. They're not friends. And, while we're at it, the moment you treat a friend like a stranger (form mail, for example) they're not a friend any more, are they?)"

(end quote)

My comment: Will you be more than a 'friendlies' and be my friend?

World's Priciest Emerging Market Properties

The Real Estate Business Intelligence Services (REDIN) showcases the most expensive properties in the emerging market world as categorized by...

Residential
Office

Retail

Industrial

and Land

(HT: Paul Kedrosky)

War on Drugs: Learning From Portugal's Drug Decriminalization

In an earlier post,[see Nicolas Kristof: Why The War On Drugs Is A Failure], we dealt with the unorthodox suggestions of how to deal with the Drug menace.

Drugs isn't just a social problem, it encapsulates economic, political and the regulatory dimensions. Hence, the required approach should be holistic than simply "moralistic".

Of course, theories won't be persuasive if unmatched by actual experience, thereby, Portugal's 7 years experience on the drug decriminalization path could serve as noteworthy paradigm.

The essence of drug decriminalization seems simple: it transforms government's role from strong arm "fear-based" antagonistic approach into "mentorship" guidance, where government spends the substance of its efforts in education and treatment than from prohibition.

Moreover, the diminished operating costs enables the freeing up or shifting of government resources into more constructive means to deal with the problem, which in essence lowers the barriers of collaboration with the public.

And because the relationship switches to a more congenial climate, the impact from enforcement tends to have a high degree of success.

In short, from fear based approach to a cooperation, sympathy and treatment based solution.

The following is an article, which includes a video interview from Reason.tv ., explains the Portugal experience....

(all bold highlights mine)

Glenn Greenwald is a civil rights attorney, a blogger for Salon, and the author of a new Cato Institute policy study called “Drug Decriminalization in Portugal: Lessons for Creating Fair and Successful Policies.” The paper examines Portugal’s experiment with decriminalizing possession of drugs for personal use, which began in 2001. Nick Gillespie, editor of reason.com and reason.tv, sat down with Greenwald in April.

Q: What is the difference between decriminalization and legalization?

A: In a decriminalized framework, the law continues to prohibit drug usage, but it’s completely removed from the criminal sphere, so that if you violate that prohibition or do the activity that the law says you cannot do you’re no longer committing a crime. You cannot be turned into a criminal by the state. Instead, it’s deemed to be an administrative offense only, and you’re put into an administrative proceeding rather than a criminal proceeding.

Q: What happened in Portugal?

A: The impetus behind decriminalization was not that there was some drive to have a libertarian ideology based on the idea that adults should be able to use whatever substances they want. Nor was it because there’s some idyllic upper-middle-class setting. Portugal is a very poor country. It’s not Luxembourg or Monaco or something like that.

In the 1990s they had a spiraling, out-of-control drug problem. Addiction was skyrocketing. Drug-related pathologies were increasing rapidly. They were taking this step out of desperation. They convened a council of apolitical policy experts and gave them the mandate to determine which optimal policy approach would enable them to best deal with these drug problems. The council convened and studied all the various options. Decriminalization was the answer to the question, “How can we best limit drug usage and drug addiction?” It was a policy designed to do that.

Q: One of the things you found is that decriminalization actually correlates with less drug use. A basic theory would say that if you lower the cost of doing drugs by making it less criminally offensive, you would have more of it.

A: The concern that policy makers had, the frustration in the 1990s when they were criminalizing, is the more they criminalized, the more the usage rates went up. One of the reasons was because when you tell the population that you will imprison them or treat them as criminals if they identify themselves as drug users or you learn that they’re using drugs, what you do is you create a barrier between the government and the citizenry, such that the citizenry fears the government. Which means that government officials can’t offer treatment programs. They can’t communicate with the population effectively. They can’t offer them services.

Once Portugal decriminalized, a huge amount of money that had gone into putting its citizens in cages was freed up. It enabled the government to provide meaningful treatment to people who wanted it, and so addicts were able to turn into non–drug users and usage rates went down.

Q: What’s the relevance for the United States?

A: We have debates all the time now about things like drug policy reform and decriminalization, and it’s based purely in speculation and fear mongering of all the horrible things that are supposedly going to happen if we loosen our drug laws. We can remove ourselves from the realm of the speculative by looking at Portugal, which actually decriminalized seven years ago, in full, [use and possession of] every drug. And see that none of that parade of horribles that’s constantly warned of by decriminalization opponents actually came to fruition. Lisbon didn’t turn into a drug haven for drug tourists. The explosion in drug usage rates that was predicted never materialized. In fact, the opposite happened.

Watch Glenn Greenwald and Reason.tv's Nick Gillespie discuss both the lessons from Portugal and Barack Obama's disappointing performance so far on drug policy, executive power, and civil liberties by clicking on this link

Global Stock Market Performance Update: Rotational Effects and Tight Correlations

Another fantastic chart from Bespoke Invest giving us an update on the recent turn of events.

According to Bespoke (bold highlight mine),``Bloomberg's World Index made a rally high on June 2nd. Below we highlight the stock market performance for 83 countries since June 2nd and year to date. Since the 2nd, 14 countries have seen stock prices continue to rise, while the other 69 have seen prices fall. Lebanon, Kenya, Sri Lanka, and Mauritius are the only countries with double-digit percentage gains. The biggest country to show gains during a time when global stocks have struggled is China. China's Shanghai Composite has rallied 6.18%. The other three BRIC countries have not fared as well. India is down 3.7%, Brazil is down 7.82%, and Russia is down a whopping 21%. Russia has been the second worst performing country during the recent downturn.

``Looking at G-7 countries, Japan has held up the best since June 2nd with a decline of 1.59%. The US has been the second best at -5.21%, followed by the UK, Canada, France, Germany, and then Italy."

My comment:

If global markets have been driven by liquidity or monetary forces or inflation dynamics then it is quite obvious that there will be rotational effects and secondly, for the early movers some tight correlation, as global liquidity transmission interlinks divergent markets.

Notice that most of the today's (from June 2nd) topnotch performers (e.g. Kenya, Bangladesh, Latvia, Slovakia, Oman, Morroco, Bostwana et. al.) have had sluggish year to date gains or had earlier underperformed.

Additionally, the decline of the BRICs (except China) have been in parallel with the decline of the front running EM leaders, as well as, having tracked OECD market performance in terms of price direction over the interim.

Russia's hefty decline exhibits overheating. The Russian benchmark is still the 5th best year to date performer IN SPITE of the recent (21%) downturn. It trails Peru, Sri Lanka, China and India.

This implies of an ongoing rotation, where previous laggards are now ahead, while former leaders appear to undergo a hiatus.

Next, despite the recent correction, Emerging Markets continue to outperform developed economies, albeit at different rates-again an obvious impact from inflation dynamics-as that of being relative.

Inflation or Deflation? The Global Perspective

The following chart from Bespoke is quite revealing. It shows of the present inflation rates around the world.

We quote Bespoke (underscore mine), ``For those interested, below we highlight a big bar chart showing the most recent inflation rates for 77 countries. The average unweighted inflation rate for all of the countries is 4.11%. Fifty-nine countries are currently seeing prices rise versus a year ago, 14 are seeing prices decline, and 4 are flat. Venezuela has the highest inflation rate at 27.7%, followed by Kenya, Iran, Ukraine, Pakistan, Guatemala, and Russia. Ireland is seeing the most deflation with a year over year decline in prices of 4.7%. China has the third biggest decline in prices at -1.4%, while the US is right behind at -1.3%. Whether or not you use this chart to make any investment decisions, it does provide a good look at where each country stands in regards to price movements."

Our observations: one in four countries have been experiencing inflation in the face of the crisis.The average inflation rate is 4%.

Nonetheless, Two things clearly standout:

One, inflation is relative. Common policy programs aimed to address national problems which have been structurally idiosyncratic apparently results to different levels of inflation.

Two, for those arguing about global deflation, these chart appears to strongly refute such an argument.

To add further, consider that the present climate has yet been operating under a "benign" phase of the inflation, what more if inflation secures a strong foothold in countries impacted by debt deflation??!!!

As Edward Chancellor of GMO aptly wrote in the Financial Times, ``There is no question that a determined central bank can get rid of deflation. It is simply a question of printing enough money. Economists have another term to describe the monetisation of government debt. The history of “seigniorage” goes back to the debasement of the coinage under the Roman emperors. Seigniorage is really a tax on holders of money and government debt which is paid via inflation. When carried to excess, it leads to hyperinflation."

You've got a serious inflation crisis ahead!

Depression Stories: Are We Worst Off?

With stock markets melting around the world, what would seem more timely than to compare today's conditions with that of the Great Depression.

Here are two articles showcasing sundry charts dealing with such comparisons.

First, comes from Barry Eichengreen and Kevin O'Rourke's A Tale of Two Depressions (Hat tip: safehaven.com/John Maudlin)

Volume of World Trade worst than the Great Depression

Falling world industrial output in line with the Great Depression

See the rest of the charts here

Mssrs. Eichengreen O'Rourke concludes (underscore mine): ``To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30."

``The good news, of course, is that the policy response is very different. The question now is whether that policy response will work."

Council of Foreign Relations' Paul Swartz makes the same comparison but this time it's more US centric.

Industrial production hasn't fallen in the scale of the Depression

"Although the labor market has deteriorated more than at any time since World War II, it is much healthier than during the Great Depression."

"The federal budget has deteriorated far more rapidly than in any past recession, in part due to the first economic stimulus and bank bailouts.The current stimulus implies an even larger and more prolonged deficit in the future."

See the rest of the charts here

Concluding remarks from Paul Swartz, ``The collapse in the federal government’s finances is unprecedented, raising questions about how the government deficit will be brought under control.

``By most measures, the current recession is far milder than the Great Depression. But the appendix shows that house prices have recently fallen much more sharply than in the 1930s."

So essentially we have two opposing opinions.

Eichengreen-O'Rourke sees Depression like developments for the world and cheers on government policy actions while Mr. Swartz sees it otherwise and worries over government deficits.

That's the nature of economics, divergences in interpretations. What you see depends on where you stand-perhaps influenced politically or ideologically or from personal bias.

Marc Faber: Risk of Hyperinflation Is Very High

Marc Faber says that in 5-10 years, US inflation rates will hit 10-20%. And equities and real estate would perform better than US Treasuries.

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.