Filipinos’ “Flawed” Culture? History Is Not A Closed Book

``It’s one thing to talk about ethics, but quite another to adhere to them. An ethical person consistently acts in accordance with his code of moral values. By contrast, a hypocritical person preaches a high standard of morality, but acts otherwise.” –Robert Ringer, A Wisdom-Filled Self-Eulogy, Part II

Price is a function of exchange subjectively valued by multivariate economic actors. And exchange is a function of markets, whose output (aggregate of production distribution, services, remittances, investments et. al) determines what is known in economics as your statistical GDP or GNI.

While academic textbook defines economics as a study of how forces of supply and demand allocate scarce resources, calculations to determine such resource allocations can ONLY BE done through the concept of pricing. The failure of the political paradigm known as “communism” was primarily an UNRESOLVED problem of economic calculation under centralized planned authorities or the inability to do away with pricing or with money. Who needs money in a Utopian society, anyway?

Financial markets or capital markets, serve as a mechanism of exchange for financial products; hence they operate under the same principle. Needless to say, today’s global economic environment have been dominated by so-called “paper shufflers” where financial assets overwhelm the real value of aggregate exchange of goods and services by about 3 to 1. As evidence we cite, McKinsey Quarterly’s estimate of the total global capital stock is $143 trillion whereas global output as about $44 trillion in 2005. In short, finance dominates today’s global economy.

Since value is determined by individual minds, then markets are basically psychologically driven. Having said so, in the realm of financial markets the psychological or emotional attributes of GREED, FEAR and HOPE serve as universal variables in determining value. So, whether you are long term investor, trader or a scalper, and REGARDLESS of color of the skin, culture, religious beliefs, political convictions and etc, such attributes accompanies the way decisions are made.

So whether we buy San Miguel Corp shares in the stock exchange or we buy a bottle of San Miguel Beer in a Bar, grocery or in the neighborhood Sari-sari store (as I did last night), (The difference being that of the platform of where the exchange is conducted.), essentially you are looking at the same operating principle; MARKETS AT WORK. My simple message is that MARKETS are the economy.

In the lay context, what is all so often labeled as “economic deprivation” translates effectively to AN INADEQUATE EXCHANGE MECHANISM that result to negative ramifications of poverty, inequality or low quality of living or simply said, DYSFUNCTIONAL markets (caused by distortion or underdevelopment).

For instance, how does our agricultural worker, representing the largest workforce in the Philippine labor pie, improve on their share of income when they continue to rely on the traditional channel (market), or in particular the “traders” (who gets a big chunk of their profits), for the exchange of their produce? In other countries, including our peers, they get not only full value of their produce (by bypassing middlemen) but have the ability to HEDGE their products from variable risks factors such as weather, seasonality and etc.

Therefore, the key question is HOW to resolve on what INHIBITS our markets from functioning at the optimum for the benefit of, what politicians and their factotums by nature call as the “common good”. Yet, media and celebrity pundits frequently tackle on tangential issues to becloud the perception of the public while politicians eagerly jump on controversies to use such opportunity to impose more “controls”. Again this reminds me of one popular quote by Dr. Samuel Johnson, one of England’s greatest literary figures, ``Patriotism is the last refuge of a scoundrel."

Since psychology drives capital deployment decision making, whether motivated on grounds of political (e.g. public institutions) or economic goals, we are inherently subject to heuristics (mental short cuts) or inherent biases. After all, we are merely humans, where our ancestors have basically shaped the functionality of our minds and biases operating under survivorship conditions then. As an example, fear leads to our natural defensive reaction (against predators) such as running!

We easily succumb to oversimplifying events based on our present knowledge giving us the “illusion of knowledge”. And because we think that we know the problem, hence we usually give out our “one-size-fit-all” remedies/panaceas out of the “illusion of control” on our perceived woes.

As examples, the recent circulating email describes of our “Flawed culture” (or “national inferiority complex”), which is no other than a recycled, resurrected makeover of the James Fallows’ Atlantic Monthly’s 1987 controversial piece “Damaged Culture”, or of common polemics on overpopulation, lack of education, cultural diversity, fragmented society, pervasive “corruption”, lack of “safety nets”, patronage politics, inadequate social spending, “unsophisticated” voters and others, all of which contribute to the lack of productivity or have been cited by different quarters as responsible to the present state of our depressed society.

While all of them may have SOME influence to the country’s downtrodden state, the weightings or relevance applied are different and will continue to shift as the landscape evolves.

Because these are ALSO elements to our living and breathing network of exchanges or markets, they are predominantly multi-dimensional variable based and NOT singular factor determined operating under the evolution of dynamic environments. When we say dynamic we mean changing micro and macro dynamics, such as new regulatory environments, shifting consumer/voter preferences, demographic and migratory trends, wealth changes, climate changes, capital flows, technologically and scientifically driven advances, inflationary driven psychology, et. al..

In other words, some problems contribute more than the others while some factors may nonetheless be rendered insignificant over the passage of time.

On the other hand, external factors have likewise been shown to have grown more in influence to the structural changes in our environment. For instance, how does one reckon with the so called “lack of national identity” dilemma operating in the FACE OF EXPLODING MIGRATORY TRENDS (UN says-about 191 million migrants in 2005 and growing) under the auspices of deepening trends of globalization?

No, the migratory trends today, which used to be driven mainly by seeking for “greener pasture” have now seen other sources of impetus; global demographic requirements, “ethnic reconsolidation” to quote the Economist, taxation, politics and et. al., have not been directed merely on labor skills (although they constitute the significant majority) but to growing trends even among the investor class. Hence, could we be at the cusp of the emergence of global citizenship?

Daniel Altman who writes for the International Herald Tribune and YaleGlobal (emphasis mine) says it best, ``...citizenship is becoming less and less about patriotism. In obtaining a second or even third nationality, earning a living is often a higher priority than confirming a sense of identity and belonging. Seeking a better deal from society can also be a prime motivation.”

The issue here is that market and economic environments are highly complex in nature and continually operate under fluid circumstances, where nothing is definitive except for change.

We also read of proposed simplistic solutions to our miseries, as being “Attitude” in nature, specifically, Ethics, Integrity, Responsibility, Respect to the laws & rules, Respect to the rights of other citizens, Work loving, Strive for saving & investment, Will-accompanied by super action, Punctuality and Community service, citing nations which have openly espoused such virtues as “progressive”. While I do not contest the INTENT of the message, as it is indeed IDEAL, the truth is HOW I WISH it were APPLICABLE or REAL.

For instance, while I would agree that Respect for Property rights and Personal Responsibility are key ingredients to functioning markets, the need for savings for instance would be an arguable topic. The others look like political gimcrackery.

Of course, through the Austrian persuasion I have learned that real savings are indispensable because they represent real wealth. However, practicing Keynesians would argue, “Huh? Who needs savings in the age of derivatives? With the combination of “money created from thin air” and the dawn of “digital money”, why save or produce when we can simply speculate? Have not savings today been represented by rising asset values?”

As we earlier mentioned today’s world is more of finance, ergo a Keynesian world. No country wants a STRONG currency and thus every country works to destroy or debase the value of their currency. These are manifestations of the inflationary proclivities. Nonetheless, beyond the knowledge of the public, inflationary policies serve to benefit special interest groups associated with the powers that be (for preservation). Yet, is it not a wonder why the widening worldwide inequality gap has been a consequence of collective INFLATIONARY POLICIES adopted by Keynesian protégés ensconced in central banks and in government bureaucracies?

One should also remember that today’s leaders maybe tomorrow’s mediocre performers or that Empires operate on their own CYCLES too. Have we not been colonized by Spain for over 300 years when they were yet at the helm of the world? Whereas the 19^th century belonged to the England, the United States took over the mantle in the 20^th century following the World War I.

One can have a short glimpse of the time intervals of shifting empires since Man’s civilization began, as illustrated by mapsofwar.com, as shown in the link below:

http://www.mapsofwar.com/ind/imperial-history.html

Do you think that history ends today?

To wit, such assertion of a simplified Utopian solution have been grounded on cognitive biases such as “framing” [wikipedia.org-cognitive heuristic in which people tend to reach conclusions based on the 'framework' within which a situation was presented], “representativeness” [James Montier of Dresdner Kleinwort--the judging of events by how they appear than they likely are] and “fallacy of composition” [wikipedia.org-one infers that something is true of the whole from the fact that it is true of some (or even every) part of the whole].

For instance Japan having been mentioned as one of such virtuous examples/practitioners. If they have been so puritanical, why have Yakuza’s (Japanese Mafias) thrived in such environment?

Or consider the suicide rates; among developed countries Japan has the most incidence of suicide statistics according to WHO, 36.5 for males and 14.5 for females for every 100,000. Compared to the Philippines, 2.5 and 1.7, or India 12.2 and 9.1, respectively. Should this imply that they are richer but we are happier (reword: appreciate life)? So which among these qualities should be highly valued? Or which should determine a nation’s success, a higher per capita GDP or lower suicide rates? (Now I pose to you a counter-FRAMING question.)

You might want to know that Japan’s credit rating is at the level of Botswana, an African nation, considering its about 160% public debt to GDP. Or of its declining or shrinking population from which if present trends persists, NO Japanese will be left standing by the next century (!), to paraphrase an official.

Who then pays for all of the debts incurred by them UNLESS they radically change, in terms of culture, i.e. to accept immigrants as part of society, empower female to close the gender gap and to increase fertility rates, and in politics, i.e. allow further ingress of immigrants? [Faced with Hobson’s choice, the inevitable reform path makes me bullish on Japan].

Morality, argues Steven Levitt and Stephen Dubner, ``represents the way that people would like the world to work-whereas economics how it actually does work.”

If history were likewise determined by such idealistic virtues, then John Lennon’s world of “Imagine” would possibly be realized on a pragmatist level and we would all be living in harmony with reduced conflicts. Yet as shown above history belies such utopian setting.

Yet the problem with moral solutions lies in its DEFINABILITY. The broad coverage makes them seem like motherhood statements mouthed by political demagogues. Another, moral solutions usually serve as cloak for more regulations or Spending Other People’s money (SPOM), which in most part have been the ROOT cause of the market asymmetries here or elsewhere.

In addition, we can argue about Switzerland’s success (specialization) or of Canada and Australia (market and commodity driven economies) or of Vietnam (China modeled-liberalization), but moralizers make the same predictive fallacies as that with typical market analysts; projecting past performances into the future.

For example, to argue that India is poor and imply to remain so (Oh yeah?), simply because they do not follow the said virtues, is predicated on the analogy that mechanical rotary telephones will never change.

Figure 1: Goldman Sachs: BRICs on the Run

The emerging markets phenomenon known as the Brazil, Russia, India and China or BRICs as labeled by Goldman Sachs shows if the present clip of growth rates were to persist, your unvirtuous paragon will SURPASS the virtuous ones as shown in Figure 1. Says the Goldman Sachs study in 2005 (emphasis mine),

``They suggest that if things go right, the BRICs could become a very important source of new global spending in the not too distant future. The chart below shows that India’s economy, for instance, could be larger than Japan’s by 2032, and China’s larger than the US by 2041 (and larger than everyone else as early as 2016). The BRICs economies taken together could be larger than the G6 by 2039.” The assumption here is for present conditions to maintain its pace which is a big IF going forward.

Yes, the meaningful transition in support of these evolving trends are becoming more apparent, this latest account on the convergence of global pay for managers, according to Financial Times (emphasis mine), ``Forecasts of wage increases in more than 50 countries, published by consultants Hay Group, reveal that real pay is predicted to race ahead in Asia and eastern Europe this year compared with the "developed old economies". Faster wage growth reflects "the wealth creation being generated by rapid economic acceleration in China, India, the former eastern bloc and the Baltic states," says Hay.”

Again, if such trend persists, the income levels for managers in today’s developing “POOR unvirtuous” countries (Philippines, India, Vietnam Egypt or others) and the developed world could reach near PARITY sometime in the distant future!

Nor is it limited to wages, Forbes list of billionaires shows of a growing trend of successful entrepreneurs from your unvirtuous countries, quoting William Pesek of Bloomberg (emphasis mine), ``Yet Forbes's latest tally says even more about what's happening within Asia. India wrestled the top spot in Asia from Japan, which held the title for two decades. India has 36 billionaires with a total of $191 billion; Japan has 24, with a total net worth of $64 billion....Following the money offers insights on the changing of the guard in world's most-vibrant economic region. Japan once dominated Asia, yet developing powers like India and China are moving to center stage. Expect more of the same in the years ahead.”

Before bringing this to a close, I’d like to show you another “human” cycle phenomenon which should affect the global markets, economies and or politics alike over the next few years or so.

Figure 2: Puru Saxena/ Barry Bannister, Stifel Nicolaus: Commodity Cycle

It’s called the commodity cycle. And the upturns of commodity cycles have been in the past associated with wars, simply because supply shortages create intense competition which eventually spillovers to the political arena, as shown in Figure 2.

As Dr. Marc Faber explains (emphasis mine), ``But it’s not only the commodity-importing nations that become more belligerent when shortages drive prices higher. The commodity producers themselves find they are in a sweet spot and become more aggressive in their relationship with their clients — the resource-importing nations. So, whereas we have seen that in the 1980s the balance of power in the world began to shift towards the industrialised nations as commodity prices fell, today it would appear that the balance of power has already shifted back to the resource producers — especially the oil producers. This shift of power to the resource producers is particularly pronounced when new countries and regions become involved in the “trade network”, as Kondratieff observed, because the demand from the traditional sources is, as a result of the entry of new countries into the global economy, gradually displaced by the incremental demand of nontraditional and new sources.”

Today’s upturn in the commodity cycle once again reveals of patterns of bellicosity as seen in the geopolitical developments of the Middle East (Iran, Iraq et. al.) and the rising tide of “nationalism” in Russia, Venezuela, Bolivia and others which are potential sources of future conflicts.

As historian Niall Ferguson warns in his War of the World: History’s Age of Hatred (emphasis mine), ``We shall avoid another century of conflict only if we understand the forces that caused the last one-dark forces that conjure up ethnic and imperial rivalry out of economic crisis, and in doing so negate our common humanity. They are the forces that stir within us still.”

In finale, since economies are the aggregates of functioning networks of exchanges or of markets, psychological underpinnings dictates on its cycles, most commonly characterized by greed, fear and hope.

Division of Labor enhances the exchange mechanism and allows for more social cooperation which leads to the so-called ATTITUDE “moral” solution. The successes or failures of economies have been ascertained by multi-dimensional variables which influence on the degree of the operativity of the markets.

In essence, the FUNCTIONALITY OF MARKETS ESSENTIALLY DETERMINES THE WEALTH TRANSMISSION. The so-called success formula has ONE coincident denominator, a market based economy.

Critiques or analysis of perceived inadequacies accompanied by “moral” solutions based on “selective” information reveal of MENTAL DISHONESTY and or the lack of understanding of the dynamics of market based cycles and evolutionary shifts in the global economic landscape to pass “undeserving” judgments.

The risk is such that we fall into the cognitive traps obviously laid by vested “political” interest or their functionaries to promote regressive policies camouflaged in the name of “common good”. Worst of all, is to repeat the same mistakes of our forebears.

Remember, today’s commodity cycle tell us that shortages and rising prices have tendencies for hawkish attitudes that may lead to undue “belligerency” or aggressiveness. It would be better for us to promote social cooperation via increased trade and work on to improve on our markets than to undergo violent upheavals brought about by the order of closed societies “nationalism” or “myopic” populism.

With regards to the Philippines being a “Damaged or Flawed” culture, history is not a closed book. Believing so, only imprisons one to corridors of the past.

A Correlation Is A Correlation Until It Isn’t

``We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe nothing's happening...the initial pop seems like a random event until the second occurs. A third. A fourth. Then the popping goes wild."-Richard Bernstein Merrill Lynch chief investment strategist quoted in Time magazine.

There has not been much change in the markets this week since shakedown began at the end of February. For the moment, we still see a semblance of the same variables that appear to be influential forces at work.

Our Phisix was down 1.21% over the week, as global markets appear to be on a downward trek. Our inspirational leaders the US markets have likewise been down, the Dow Jones Industrials lower 1.35%, S&P 500 1.13% and the Nasdaq .62%.

In the meantime, we saw the Japanese Yen significantly higher up 1.19% while the Swiss Franc likewise higher 2.17%. The significance of these currencies as we have mentioned previously is that they have been presumed to have acted as FUNDING currencies for the so-called CARRY TRADE arbitrage, where the yield spreads against the other currency pairs, have been used as leverage to invest into other asset classes. Such has been said to have provided for the gains in the global cross-asset markets via increased liquidity, which has supported risk taking activities.

The recent turn of events has demonstrably been coincidental with the movements of such currencies giving credence to the belief that the CARRY TRADE could have been a significant factor in the recent upsurge in volatility. Declines in equity and credit markets have been simultaneously seen with the ferocious rally in the Funding currencies.

Yet, this phenomenon called the CARRY TRADE has gone against the traditional economic wisdom called “uncovered interest parity” where to quote the Economist (emphasis mine),

``Countries that offer high interest rates should be compensating investors for the risk that their currency will depreciate. In other words, the forward rate should be a good guess of the likely future spot rate.

``In the real world, uncovered interest parity has not applied over the past 25 years or so. A recent academic study has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. Carry-trade strategies would have brought substantial profits, not far short of stockmarket returns, although dealing costs would have limited the size of the bets traders could make.”

In other words, some traditional economic theories as cited above do not seem to apply in today’s rapidly evolving marketplace. Such is the reason why markets may seem so illogical, simply because they act to defy on our beliefs or of past paradigms. Again, the lesson being that past performances does not guarantee future outcomes.

I, for one, while being a skeptic, have observed at this amazing “circumstantial evidence” of correlation, but would not simply write off the possibility or probability of its causal relations with the actions in the financial markets today.

Since the world is undoubtedly extremely leveraged, the carry trade could simply be a part of the growing mechanism to accommodate more leverage.

Nonetheless many analysts, some of whom I highly respect, dismiss on the premises of its correlation based on the lack of direct evidence, in the form of official flows. The Bank of International Settlements (BIS), an international organization of Central Banks, have largely been neutral about this, as evidence have been “mixed” based on global claims as shown in Figure 3.

Figure 3: BIS Tracking the Carry Trade

Claims in Japanese Yen or Swiss Francs have not established any material footprint as with regards to the much touted CARRY TRADE in play. Although the BIS admits that quantifying or measuring the volume of carry trades have been “problematic”, the best evidence they could come up with could be seen via Forex Futures.

According to Patrick McGuire and Christian Upper of BIS, ``Data on open positions in exchange-traded FX futures in potential funding and target currencies provide the strongest evidence for a growth in carry trade activity in recent months. Noncommercial (“speculative”) short positions in yen futures traded in the United States rose between mid-2006 and late February 2007, particularly during periods of yen depreciation (Graph B, righthand panel). By contrast, speculative short positions in the franc yield little evidence of an increase in futures-based carry trades over this period. Data on speculative long positions in FX contracts on the main developed-country target currencies increased considerably in the second half of 2006, but declined somewhat in early 2007 (Graph B, right-hand panel), consistent with the rise and subsequent fall in the carry-to-risk ratio over this period. However, the weekly movements in this ratio appear to explain little of the changes in speculative positions, although the relationship is statistically significant for some currencies”.

As we always say, a correlation is a correlation until it isn’t. While our aim is to distinguish signals from noises, we see correlations as possible clues for signals in determining the future directions, as in the case of the Phisix and the Philippine Peso shown in Figure 4.

Figure 4: Inverse movements of the Phisix and the Peso

The blue arrows above shows of the inflection points of the Peso and coincidentally they have also proven to be counter inflection points for the Phisix, represented by the red arrows. When the Peso declines relative to the US dollar, the Phisix falls vice versa. The correlation seems to have become emergent in 2005.

I have asserted in numerous occasions that portfolio flows at the margins have determined the price variability of the Peso, in contrast to the conventional wisdom that remittances have been its key driver or of other factors suggested by our experts.

If my observations remain valid or cogent, we will see the same patterns unravel as the Phisix corrects or consolidates on the GROUNDS of foreign portfolio outflows on the “reappearance” of global risk aversion.

I believe that markets always convey some latent messages via its price action, so I listen to them and heed their messages instead of trying to “rationalize” or deliver a simplified explanation on their behavior in contrast to our experts or my contemporaries.

My observations of the Peso’s correlation have not been limited to the Phisix but also for Philippine sovereign bonds. In short, circumstantial evidences points to the validity of my theory that the Peso asset classes are set at the margins by portfolio flows.

Figure 5: Asianbondsonline.org: Philippine Sovereign 2 year and 10 year yields

As you can see in Figure 5 courtesy of Asianbondsonline.org, the spike in the Peso over the same rising risk aversion event in May of 2006, simultaneously manifested a jump in the USD relative to the Peso, the decline in the Phisix and equally a jump in yields (falling bond prices) for Philippine sovereign debts.

If I am correct that the countertrend phase is still at work, then the likelihood is that all three markets could show of the same degree of correlation over the interim.

Finally, I still think that today’s market activities are natural cyclical transitions playing out unless proven otherwise. Question is if we are going to see fundamental support for this decline, particularly on the risk of a US recession, this raises the risk of greater degree of volatility.

However, unlike in 2006, today’s shakeout has NOT seen a safe haven rush towards the US dollar. Instead the US dollar, as measured by its Trade weighted Index, continues to swoon even as volatility continues to snowball.

While others argue that emerging markets will drop like a stone if the US goes into a recession, in contrary, I think that the emerging “stagflationary” environment in the US will translate towards further decline in the US dollar and be supportive of the precious metals class and of the emerging markets.

The likelihood is that we will see a departure from presently aligned correlations of ALL market classes with those that thrive under such defined environment.

Following former banker and Citicorp Chairman Walter Wriston’s (1919-2005) principle, ``Money goes where it is wanted and stays where it is well treated”, Asians have treated money well relative to its Anglo-Saxon counterparts and therefore, money flows should be expected to continue.

Hope is A Good Companion But a Poor Guide!

``Risk can be a friend or foe and as an investor you will succeed or fail depending on how you deal with it. Risk is inherent condition of all investments and should be respected, assessed, managed and prudently controlled.”-Ed Easterling of Crestmont Research, Risk is Not a Door Knob

TO some, my words of caution have been viewed as displeasing or unwelcome, as I had been expected to play the role of a perpetual cheerleader for the markets. There are even those of you who think that my views as that of a messenger of doom, a party spoiler. ``Therefore, whoever thinks he is standing secure should take care not to fall.”-Corinthians 10:12

Yet the reality is that parties don’t last. They never do. And betting on unfounded optimism can result to capital losses or mental anguish or a combination of both. As market savant Andy Kessler quotes his friend, ``The stock market trades to inflict the maximum amount of pain”. Pain especially for those who apply vanity to the markets. As we have said before, people get what they deserve.

You have to understand that my sustenance depends on being MAINLY profitable, which means reading, analyzing and acting right. Even when we maintain certain convictions, we certainly avoid from FIGHTING THE TAPE because previous experiences tell us that doing so leads to emotionally wrenching losses. Instead, we treat the trend as our friend. And even among hardcore chartists, they will tell you that markets are rangebound 80% of time and trends only 20%.

While we may not be always precise, we can consistently be profitable for as long as we principally act to PRESERVE our capital. And in doing so, we bank on the wisdom of Aesop’s principle with the foremost question in mind, is the bird in the hand is worth more than two in the bush?

Yes, our market operates in a juvenile state, such that it has been a ONE WAY street for investors; one can only earn from consolidating or advancing markets. When the cycle turns, all our investors can do is to sit on the sidelines and wait. Having said so, our fate depends on these conditions unless hedging facilities do come on stream. To my knowledge, hedging facilities such as short trades or the development of the option markets are still on the design boards yet [shorting may come soon].

In my case, I have made use of the advancement of technology and globalization trends to position on the overseas markets, particularly on Asian markets, as to diminish my home bias [expand my country risk profile] and reduce my dependence on the developments in the local markets.

In the aftermath of the recent tremors in the global markets, the bulls have been quick to respond with the conviction that the recent drop would be quick one, where like a storm, would be gotten over with soon. I do hope so too. But as Mark and Jonathan Finn of the Vantage group says ``HOPE is a good companion but a poor guide”.

Phisix: Market Indicators Suggests for Further Corrections

``Markets are cyclical – always and forever. As share prices oscillate between lofty valuations and lowly ones, investor perceptions oscillate between greed and fear. When investors are fearful, they demand a large margin of safety from the assets they buy. But when they are fearless, they worry less about safety than an intoxicated teenager.-Eric Fry, Whack-A-Risk Rude Awakening

Figure 1: Corrective Phases of the Phisix

Judging from past experience of if one would use past data to extrapolate on the future, the shortest corrective phase of the Phisix since 2002, was in 3 months, i.e. October 2004 to January 2005, as shown in Figure 1.

The end of the corrective cycle is determined by its breakout from its previous high. The numbers indicated in the chart shows of the months it took for the Phisix to eventually supersede its previous highs.

As you would notice, one of the core pillars of my analysis has been anchored on the understanding of market cycles, where market cycles are principally determined by psychology as previously defined. And the present market cycle implies that the corrective phase is a natural phenomenon.

Since the start of the cyclical reversal in 2003, declines as measured by peak to troughs had an average period of about 2 months, where if applied to the current settings (topped at February 21) would possibly translate to a trough sometime latter April. (That’s IF the cycle plays out as in the past! But what if HOPE or the bulls are right?) The rest of the months which follows the trough represents as the healing phase or a period of consolidation segueing into gradual ascendance.

There is also the seasonality factor. You’ve probably heard of the axiom “Sell in May and Go Away”. While this may not always hold true, it simply implies that the seasonal periods of May [50:50 for May-June in a span of 22 years] heading towards the third quarter COULD be the weakest link for stock performance.

In other words, based on cyclical and seasonal factors alone, the odds for a short-term massive comeback looks obscure, or your two birds in the bush in exchange for the present one comes with significant obstacles.

Yet this does not even consider the degree of the upside gains relative to its possible percentages retracement.

If one were to use the Fibonacci figures, based last July’s trough until the peak of February 21 as possible indicators, the levels of retracement are at 2,890 (38.2%), 2,750 (50%) and 2,550 (61.8%). Pardon me for practicing financial astrology [in accordance to Benoit Mandelbroit’s thoughts on chart reading] here. So far the Phisix has yet to reach any of these natural retracement or fallback levels which may suggests of further room for retracements.

Question is, with the current developments and at present levels is it worth the risk to underwrite?

US Markets: Risks of Ponzi and Speculative Finance

``Liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets".-Albert Edwards "Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity", Dresdner Kleinwort Global Strategy Report

One could always argue to say that since the Phisix has been inspired by global markets, particularly the US benchmark Dow Jones Industrials, wouldn’t it be more practical to compare the directional path of the Phisix to its developed market counterparts? Let’s see.

First, speaking of risks, I’d like to first borrow PIMCO’s Paul McCulley quote of the Hyman Minsky, the father of the Financial Instability Hypothesis, where the transitory structure of the credit markets shifts from one marked by stability to another which eventually destabilizes. The Financial Instability Hypothesis was first articulated in 1974 but published in 1991, whose excerpt is quite academic yet I think presents as the real menace to today’s finance-driven economies (emphasis mine)...

``Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on ‘income account’ on their liabilities, even as they cannot repay the principal out of income cash flows. Such units need to ‘roll over’ their liabilities – issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes.

``It can be shown that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

``In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Evidence shows that “Modern Finance” has been underpinned by such transformations into the above “speculative finance” and “ponzi” spheres, such as the proliferation of “structured finance”, derivatives, and other innovative financial products.

Some hedge funds are even said to have employed by as much as 50 times leverage relative to its capital, where a 2% decline in the securities invested would effectively translate to complete or 100% capital loss! In other words, the ocean of credit creation and intermediation has led to diminished returns, more risk undertaking, narrower spreads and the seeming ambiance of low volatility, where in true dimension reveal nothing more than inflationary manifestations accommodated by the global governments. Such processes are natural offshoots to the order of Paper or Fiat money standards.

I was recently asked of what I thought would be the probable effect of former Fed Chief Alan Greenspan’s pronouncement that the US had ``one-third probability'' of a U.S. recession this year. Further, Mr. Greenspan likewise noted that the current expansion won’t have the same degree of endurance compared to its decade long predecessor, quoting Mr. Greenspan ``Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter' and is likely to be this time”.

While my reply was to essentially heed the signals of the different markets, my humble opinion is that it would be better for the US to undergo such adjustment process for country to be able to cleanse the excesses built into the system.

In exchange for short term turbulence would be gains on a sounder footing over the longer term. Does it not follow in the context of economic cycles that the next phase after recession would be a recovery? So what is so bad with a recession?

Although my main concern has NOT been that of a technical US recession, but of a possible implosion of leverage that could affect the entire global financial and monetary structure and cancel out the present gains in the system.

Figure 2: Casey Research: Exploding Derivatives

Figure 2 from Doug Casey shows of the exponential growth of OTC derivatives, one of the potential epicenters for the markets’ dislocation, quoting Mr. Doug Casey (emphasis mine),

``The collective result is that our financial system has been wired up to $370 trillion dollars of privately negotiated investment contracts. They’re usually written to shift risk from one bank, pension fund, insurance company or brokerage firm to another. And many are linked together in long chains, with each contract providing collateral for the next.

``It’s all very clever, but layering the enormous size– $370 trillion dollars, far more than the net worth of all the financial institutions in the world – on top of all that complexity is downright scary. In simpler times, a home loan going bad would affect only the particular lender. Enough defaults would put the lender out of business. And that would be the end of it. But today a wave of defaults can send a shock through the portfolios of financial institutions around the globe, including hedge funds, banks and pension funds far removed from the troubled borrowers.”

Yet the optimism exuded by the bulls have been premised on the notion of a BERNANKE PUT, where the FED or the Working Group of Financial Markets a.k.a. Plunge Protection Team would intervene and provide for the liquidity of last resorts to the finance driven US economy.

For instance, Jeremy Siegel of Wharton in his interview debunks risks of emanating from hedge funds (emphasis mine), ``Could they precipitate a crisis? Not with the Fed on top of it. The Fed can diffuse any crisis. If everyone gets on one side of the market and things are out of control, the Fed is the ultimate source of liquidity. I think that they can prevent that from spinning out of control. So at this particular point, let people follow those paths that they think are most profitable.”

There are those who claim that the US government would not step in to the rescue of the US economy as evidenced by its non-intervention in the ongoing subprime woes. Past actions have not been substantiated by this claim, namely the S&L crisis, Tequila Crisis, Asian Financial Crisis, Russia Crisis, Y2K jitters, the most recent Dotcom bust or 9-11, where the FED responded with liquidity injections.

These actions by the FED have in fact spawned the overconfidence and increased risk taking appetite as denoted through by Mr. Siegel’s comments that governments are always there to cushion investors from the market’s volatilities. And reading through the present action, the recent ruckus in the markets has NOT BEEN SIGNIFICANT enough to openly prompt for any action from the FED YET (they are still quibbling about inflation!).

Whereas even if FED were to intervene both Mr. Paul McCulley of PIMCO and David Rosenberg of Merrill Lynch suggests that such meddling would be least potent or would not have much significance to mitigate on the effects of the ongoing hemorrhage in the housing industry.

In the astute words of Paul McCulley (emphasis mine), ``It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand.”

From Merrill Lynch’s David Rosenberg as quoted by the Daily Reckoning (emphasis mine), ``“What drove the housing-led cycle was not as much the cost of credit, but rather the widespread availability of credit - irrespective of your FICO score [a measure of your ability to repay]...only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

In other words, the bleeding in the housing industry would not be stanched by the prospective FED intervention by the lowering of interest rates, from which the financial markets have mostly priced in their gains from. Both expect the housing woes to diffuse into the greater segment of the economy, which enhances the risks of a greater- than-expected slowdown.

Another example of Ponzi-derived leverage is the YEN Carry arbitrage. While some analysts have debunked the extent of its influence due to lack of concrete evidences from official fund flows, the coincidental effects manifested by the movements of the Japanese Yen and the global markets have been simply so compelling to dismiss.

Figure 3: Stockcharts.com: Overblown Carry Trade?

In figure 3, the initial impact of the Yen’s (superimposed line chart) surge coincided with the tremors in the global equity markets represented by the Dow Jones Industrial Averages (candlestick) and the Dow Jones World Index (lower pane) as shown by the blue arrows. Last week’s steep selloff in the Yen have likewise mirrored the rally in the Global markets (green arrows).

Many argue that macro factors as demographics (aging population seeking higher returns), as well as micro fundamentals as the tentative growth outlook have not been supportive of a sustained rally in the Yen.

Figure 4: John Murphy: The YEN on MAJOR SUPPORT

According to the Economist quoted last February, the Japanese Yen has been undervalued by 28% (!) against the US dollar based on the Big Mac Index and 40% (!) undervalued against the Euro, making it the world’s most inexpensive major currency!

As figure 4 from John Murphy of stockcharts.com shows, the Yen sits on massive multi-year support levels seen in the EURO (left window) and the US dollar (right window). Testing critical support levels of this nature could be expected to incur violent reactions of which we had earlier witnessed. Nonetheless, the YEN on both pairs have been extremely oversold and should naturally begin its ascent.

What significance does this imply to global markets? If the camp of analysts who claim that the YEN trade has not been a major factor in the recent carnage are right, then we could expect the financial markets to simply shrug off any potential rise in the Yen as it bounces of the major support area.

On the other hand, if what we observed would continue to dictate on the market’s interim actions then a rising yen could UPSET any actions initiated by the bulls which would imply for more selling pressures.

Figure 5: Economist: Reintroduction of Risks

The global contagion has reintroduced the concept of risk where it has once been thought to have gone into hibernation as shown by Figure 5 from the Economist.

Figure 6: Northern Trust: Corporate Equities: Supplies go Down, Price Rises

If you think all the tremendous money and credit generated and distributed had been channeled to “productive” investments, Figure 6 from Northern Trust reveals that the recent winning streak in the financial markets have been likewise due to the massive “retirement” in the supply side of equities emanating mostly from the idle surplus capital from corporations and private equity deals.

According to Paul Kariel of Northern Trust (emphasis mine), ``As one can see, a record $548 billion of equities were “retired” in 2006. This is not only a record retirement in dollar terms but also a record relative to nominal GDP. Rather than engaging in a capital spending boom with their recent profit largesse, corporations have been buying back their publicly-traded equity shares with abandon. In addition, the surge in private equity activity has retired shares. So, with the record contraction in the supply (in flow terms) of shares, is it any wonder that the price of shares rose last year?”

Yet Mr. Kasriel further notes that foreign buying has mainly been providing support to these share “retirements” while at the same time HOUSEHOLDs directly or indirectly have used this to finance consumption in place of a slowing mortgage equity withdrawal.

The problem is that as the housing woes deepens, source of funding for US consumers becomes more strained unless they curb their spending patterns and or grow their income faster and or the clip of supply side “retirements” accelerate and or discover other alternative sources for liquidity generation (possibly more debt). This anew poses as another variable which may present itself as more risk to the bullish premises.

The dynamics of share “retirements” or buybacks by corporations coupled with record amounts of insider selling prior to the recent selloffs can be viewed as circumstantial evidences in the light of non-productive investments in support of a privileged few. The growing income inequality gap in the US is nonetheless a manifestation of the continuing “Monetary” inflation policies and the unsound practices of the present Paper based money system.

Finally, whether the recent tumult was due to the Japanese yen, dislocation brought about by unwinding leverage, escalation of mortgage woes, decelerating earnings growth, reversal of expected “liquidity of last resort” or the “Bernanke Put” from the Fed or the lack of continued support from foreigners on the supply side of the equities equation or questions on the sustainability of debt driven consumption or inverted yield curve or the much loathed “R” word-whose probabilities appears increasing by the day, all these points to the horizon where the markets looks increasingly tilted towards heightened volatility going into the interim future.

Risk only amounts you can sleep on; buy on panics and do tighten your stops.

Phisix: Playing Out Our Script

``Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success.'' –Warren Buffett

Finally, the market plays out our long and much awaited script!

While it may be close to impossible to determine such timing with pinpoint precision, market CYCLES eventually PREVAIL.

We had earlier described the local market as “knocking” on history’s door based on the bullish momentum in an attempt to crossover the resistance level. We also observed that budding speculative fervor from within represented risks of EUPHORIA, where similar circumstances in the past alluded to imminent TOPS. [The Phisix fell 7.35% over the week!]

We also discussed of the extreme bullishness as not being confined to the premises of the domestic arena and that the pervasive winning streak in global equities has led to similar sentimental buoyancies here and abroad. We even cited China and Vietnam experience as examples of a brewing “mania”. [China fell 9.2% in a single day!]

If there is any one indispensable lesson from this week’s activities, it is that WORLD dynamics and NOT local events have now proven to be the major determinants of the directional paths of our market, in stark contrast to what has been long promoted by our “experts” and the media. FINANCIAL GLOBALIZATION has been its KEY catalyst, where as described over and over again, as with the shared benefits comes with it the risks of contagion. [World markets from the Americas, EUROPE, Asia and MENA regions have taken a beating!]

Moreover, because of the growing significance of the asset markets in shaping today’s “finance-based” economies, governments have been sensitive to such developments and have attempted to extend CONTROL, which has lead to UNINTENDED consequences. Last week’s “Shanghai Surprise” as some market pundits call it, a crash which resonated around the world, and previously in Thailand serves as concrete examples.

Lastly, as also described in the past, RANDOMNESS, or aptly known as “Black Swan” or HIGH SIGMA standard deviation or “FAT Tail” [low probability but high impact-events], applies to the market beyond the confines of any sophisticated high tech mathematical or chart models. Here, past actions have failed to determine future activities. [There is much surprise to the markets than we are wont to believe.]

The Blame is on China’s “Shanghai Surprise”, But....

``Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” -- George Soros

MEDIA has been plastered with reports that China’s “Shanghai Surprise” was the culprit to last week’s highly volatile activities worldwide. Nonetheless, the public including many analysts openly embraced such supposition.

As a disciple of the market, we try to keep in mind the premises of Frederic Bastiat’s theory; “That which is Seen and that which is UNSEEN” or the parable of the Broken Window. The theory essentially deals with OPPORTUNITY COSTS.

What is SEEN today is that CHINA’s crash virtually CAUSED the maelstrom in the global financial markets last week.

While it may be true that the initial tremors in the global markets have been staged at China, the predicated causality is very much in doubt. In other words, I do not share what I perceive as a logical fallacy POST HOC ERGO PROPTER HOC “after this, therefore because of this” as espoused by the mainstream.

Figure 1: Bloomberg: Shanghai Composite: Not The First Time!

The market usually responds to a shock violently. But, in the case of China, this is clearly not the first time! Morever, the last shock happened in less than a month’s period!

In Figure 1, courtesy of Bloomberg, China’s bourses have come under siege from its authorities trying to rein in the “bubble-like” phenomenon in its equities market.

In late January of this year, according to a Forbes report, ``Cheng Siwei, vice-chairman of the National People's Congress, warned investors not to engage in speculative activity in the stockmarket because of the risk of a bubble developing and bursting, causing heavy losses, the Financial News reported.”

The warning allegedly contributed to a harrowing one day 6.5% decline as exhibited by the red arrow on both the Shanghai and Shenzhen bourses. Yet, the world has basically ignored such happenstance.

Could this suggest that since the world discounted the earlier drop, that the bigger magnitude (9.2% on Tuesday) had more of an impact to trigger a domino effect? I doubt so.

Second, one must be reminded that China’s financial markets are severely constrained by choking government regulations, where both domestic and foreign investors have limited options. Edmund Harriss of Guinness Atkinson describes best the conditions from Ground Zero (emphasis mine),

``The Chinese stock markets are in reality very thin in terms of market participants. In spite of the huge numbers of brokerage accounts a small number of funds, companies and high net worth individuals dominate the market. And they invest on the basis of Technical Analysis (i.e. price patterns) and News Flow, not on Valuations.

``The markets are also ring fenced by China’s closed capital account that means there is no general freedom to move money in and out of the Yuan or in and out of the country. Foreign investors are allowed into the domestic market but on highly restrictive terms and local investors are not allowed to go outside except on highly restrictive terms.

``So local investors don’t really have a choice. Or they do, but not a very attractive one. They can invest their money in bank deposits which will pay 2.52% for a one year deposit; or they can buy a 2.5% guaranteed return product from an insurance company; or they might invest in government bonds that currently yield under 2.65% for the ten-year, if they can get them. No wonder that when they see a hot thing they are on to it.

``But this means that Chinese stock markets do not adequately reflect local economic conditions, in our opinion and therefore should not be used to predict global ones. High volatility and high valuations are part and parcel of inadequately functioning stock markets.”

In an interview at Bloomberg, the illustrious veteran Mark Mobius of the Templeton fund basically shares the same view that China’s market is overvalued whose present activities shows disconnect from economic realities. Mr. Mobius thinks that China’s bourses will continue to suffer from selling pressures over the interim.

Figure 2: LA Times: Tail Wags the Dog?

Third, it is important to note that for a domino effect to take place means having a significant correlation on certain variable/s. In this case the connecting factor should be accessibility of foreign money to China’s equity assets. Yet, Mr. Harriss mentions that investments from foreign investors are as limited. LA Times estimates that these accounts for less than 3% of its market value.

Theglobeandmail.com quotes Arthur Kroeber, director of Dragonomics Research in Beijing in estimating the size and depth of the Chinese market, ``Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares...Only about $400-billion worth of shares can be legally traded now, and of this amount, only about $160-billion are held by retail or institutional investors.”

Globeandmail.com continues (emphasis mine), ``This means that 60 per cent of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status.”

This brings us to question on the foundations of the “China-driven contagion”; how SIGNIFICANT can it be for China’s $400 billion worth of tradeable shares or even less (remember 60% held by the ruling class) or $1.3 trillion of market cap [representing a measly 2.2% of the aggregate global market cap, see figure 2] to severely AFFECT a northward $70 trillion in world market cap?

The corollary is to suggest that Philippine market’s crash (market cap about US $80+ billion) CAUSED the carnage of the China’s bourse. How awkward can such reasoning be!

While I am seeing a sea of blood across the world’s bourses following Tuesday’s selloff, it is noteworthy to observe that Vietnam has been entirely unscathed and continues to race upwards with an amazing 5.95% advance over the week! In other words, because Vietnam’s stock market has a similar construct to that of China, i.e. restricted foreign investments, it has been less susceptible to global capital flow dynamics and relies on domestic developments as its main driver.

Remember in this age of digitalization, we are talking about global money flows at the click of a mouse. It is worth repeating that while China’s market cap is ONLY US$1.3 trillion, where about $200 billion is essentially exposed to the public or could be owned by foreign money! In contrast, our domestic market has been dictated by foreign money accounting for more than HALF of its turnover since the cycle reversed in 2003. This subjects us to the shared risks and benefits of a globalized market.

In addition, China’s loss of ten percent (10%) in nominal terms is equivalent to only US$ 130 billion, in contrast to the aggregate US market cap, which at an estimated US $27 trillion (NYSE, AMEX, Nasdaq et. al.), lost US $810 billion or 3% (rounded off) or about two-thirds of China’s market cap! So which do you think is suppose to have a larger impact on global markets?

Fourth, while it is said that the new rules imposed by the Chinese authorities aimed at curbing rampant speculation as being responsible for the carnage, this seemed to have a belated effect. According to Barry Ritholtz (emphasis mine),

``China's Shanghai and Shenzhen stock exchanges issued on Sunday the new rules of regulating their member securities companies in a bid to ward off risks in stock trading. The rules, which will come into effect on May 1, set limits to the varieties, methods and scales of stock trading that dealers are allowed to conduct, preventing them from engaging in high-risk business beyond their capacity.

``Note that these details were released on Sunday, and on Monday Chinese markets set new all-time record highs! Indeed, despite recent official discussions of new capital gains taxes, increased regulation and the government's desire to reduce speculation in China, their indices had advanced 13% in the prior six sessions -- all setting records.”

Where markets are supposed to react to new information supplied, a seemingly belated effect implies detached reality. In other words, China’s market fell NOT on the NEW rules but on some other underlying UNSEEN factors.

With the snowballing signs of mania, where people have now been borrowing against their homes to gamble or “dubo ji,” or the slot machine, as the New Times calls it, on the stock markets, the government perhaps or probably made use of their sizeable ownership of listed companies to douse on the brewing irrational exuberance by dumping their shares.

Why? Perhaps for political survival, Morgan Stanley’s Stephen Roach thinks that the present leadership views market intervention as part of measures to stabilize the situation, he writes (emphasis mine), ``In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system.”

In short, for investors, it is hard to earn on markets where the APPARATCHIKS DECIDES TO PLAY GOD!

Anyway, I don’t think much of the market actions in China would diffuse into its economy or translate to a consumer crisis, considering that only about 8% of the household assets as estimated by the Mr. Harrisss of Guinness Atkinson are exposed to equities (76% in bank deposits, 9% bonds, 7% insurance). You’d have to look elsewhere for a compelling case that could trigger a “domino effect”.

For all its worth, I believe that the global markets have simply used the “Shanghai Surprise” incident as merely a scapegoat for something much deeper, yet the public has warmly accepted such logical fallacies as “truths”.