Reading Market Signals and Avoiding Logical Fallacies

``So we pour in data from the past to fuel the decision-making mechanism created by our models, be they linear or nonlinear. But therein lies the logician’s trap: past data from real life constitute a sequence of events rather than a set of independent observations, which is what the laws of probability demand.” Peter Bernstein

To our experience, there are two major common misperceptions of what drives the financial markets. In the case of the stockmarkets, the public generally believes that its directional path, in the absolute sense, is determined by either the conditions of the domestic economy or corporate earnings.

To question or to challenge such premises is almost equivalent to blasphemy; we get stared in the face with “shock and awe” kinesics with the implication that we either…come from another planet or…don’t know what we are talking about.

To be clear, like our contrarian view on the Peso, [see November 5 to November 9 edition What Media Didn’t Tell About the Peso], we do not dispute that the activities in the domestic economy and corporate earnings does somehow contribute to the pricing dynamics as evinced in the market ticker through the transmission of collective expectations, but our perspective is angled from the functions of correlation and causation in accordance to the conveyance of information from price signals.

As an example, as we recently cited, the popular view of the Philippine Peso’s strength has been constantly attributed by mainstream media to the grounds that strong inflows from remittances have “caused” its present conditions. While from the fundamental perspective such argument appears incontrovertible, however if one looks at the price trends of remittances relative to that of the Peso, we would find some notable divergences and belated correlations, all of which does not appear to demonstrate the straightforward cogency of such assertion. This is what distinguishes us from mainstream experts.

In the news you’d frequently read experts as saying or writing in simplified gist…“the market (stocks, commodities, bonds, real estate, labor, et. al.) has been moved by so and so factors (usually event-driven)”…or the extensive use of logical fallacies of post hoc ergo propter hoc (after this therefore because of this) or cum hoc ergo propter hoc (correlation does not imply causation). There are even experts who generally draw “cause and effects” conclusions to market outcomes by interposing their underlying biases on what they believe the market should be.

Dr. John Hussman of the Hussman Funds describes this phenomenon best (highlight ours),

``Unfortunately, most economists have never fully internalized the “rational expectations” view that market prices convey information. Of course, accepting this view does not require one to believe that prices convey information perfectly (which is what the efficient markets hypothesis assumes). But where finance economists take this information concept too far, economic forecasters don't take it far enough. As a result, economic forecasts are generally based on coincident indicators such as GDP growth and industrial production, or pathetically lagging indicators. This tendency to gauge economic prospects by looking backward is why economists failed to foresee the Great Depression and every recession since.”

Since market prices are mainly shaped by psychology through expectations which are transmitted by value judgments, the myriad flow of information impacts rightly or wrongly the decision making processes of diverse market participants in different degrees. As Ludwig von Mises in Human Action says…

``It is ultimately always the subjective value judgments of individuals that determine the formation of prices…. The concept of a "just" or "fair" price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.”

For instance, similar sets of information can be construed contrastingly by market participants which could prompt for opposite market actions.

A “buy the rumor sell the news” is concrete example, once a news comes out to either confirm or deny the rumors that impelled for the recent price movements, traders usually sell (acknowledging the end of the play) while investors buy (in confirmation of expectations), ergo value judgments actively at work in the marketplace.

In short, most of the mainstream analysis which feeds on the public’s “simplified” knowledge is predicated upon the “rear view mirror” syndrome or on recent past performances. Sometimes they also reflect on the biases of these experts.

Bottom line: When analyzing markets our proclivity is to read market signals and interpret them objectively instead of imposing our biases on our perceived market realities or subjecting them to selective analysis.

Stock Markets: Monetary Policies Have Larger Impact Than Economic and Corporate Links

``This is the U.S. financial banking system and it will be defended. And if the U.S. cannot push through superconduits and rescue plans, foreign sponsorship will step up as it recently has. Whether they can pull the U.S. up or the U.S. pulls them down is another conversation altogether.”-Todd Harrison, founder CEO of Minyanville

Now going back to our original premise about “economy and corporate earnings” as drivers to the market, let us use the US equity markets as example.

Figure 1: Northern Trust: US Real GDP

Except for the recent perplexing third quarter surge in the face of a deepening housing recession and the worsening credit conditions, figure 1 from Northern Trust shows us that real seasonally adjusted GDP as measured by its percentage change since 2003 has been trending lower (superimposed blue arrow).

This means that while its economy has been growing in nominal terms, the speed of its variable changes relative to real economic growth had generally been slowing down post the dotcom bust.

Now if “economics-drives-stocks” then respectively, we should see some similarities in the price actions patterns of the S & P 500 as shown in Figure 3.

Figure 2: WSJ: Earnings Growth has been Slowing

But before we jump to the broad based index the S & P 500, a chart from an article in Wall Street Journal in Figure 2 likewise depicts of a slowdown in the year-to-year quarterly change in the earnings growth by the aggregate composite members of the major bellwether as indicated by the superimposed blue arrow over the left chart.

So again while earnings have been growing in nominal terms, the speed of its variable changes has notably been slackening since 2004.

Again if “earnings growth” equally drives stocks as commonly perceived by the public then respectively we should see some similarities in the price actions patterns in the S & P 500 as shown in Figure 3.

Figure 3: S & P 500: Quarterly Chart/Rate of Change

Figure 3 reveals of the quarterly chart of the major benchmark S & P 500 (black candle).

To compare with the performance relative to the economy in 2003, the major equity bellwether bottomed out then began its major turnaround to the upside.

In 2004 relative to earnings growth, the S&P continued with its vigorous ascent. This progressive advance has been strongly supported by the rate of change, manifested by the uptrend of the red line.

Thus, relative to price actions, the widely espoused view that “economic growth” or “earnings growth” drives the stock markets do not convincingly explain the performance of the S & P 500.

Instead, it does seem like a paradox: strong markets were coincident to slowing economic growth or deceleration of earnings growth. This inverse correlation could be described as “decoupling”, in contrast to commonly held popular views.

Figure 3: Economagic: S & P 500 and Fed Fund Futures

This is why it is imperative for us to identify, understand and monitor the driver/s that has a commanding edge to the markets, simply because by associating with the wrong cause such analysis may result to inaccurate projections and costly actions. Or in medical analogy, misdiagnosis leads to wrong prescriptive cures.

Figure 4 courtesy of Economagic provides us a more compelling correlation…market action fueled by monetary policies!

The chronology of correlation: Since the 2000 peak, the S & P (blue line) has been on a downdraft reflecting the dotcom bust. This was followed by declining Fed fund futures (red line). The S&P bottomed out in late 2002, whereas Fed fund futures bottomed in mid 2003.

Subsequently, Fed Fund futures climbed following S & P’s recovery as Fed rates hit a 60 year low. However Fed rates peaked in 2006, while the S & P continued its ascent which presently drifts at the upper ranges.

The correlation looks seductively linear, DECLINING FED RATES EQUAL TO DECLINING S & P 500 or vice versa, but appearances do not reveal everything or the caveat here is that like the folly of many analysis “correlation does not imply causation”.

Instead one should keenly observe that the S & P leads the Fed Fund Rates at critical junctures in a majority of circumstances. This has been the case except in 2006 where Fed rates paused while S & P continued to trek higher.

The clear implication is that the market’s direction is followed by corresponding Fed actions or that the US Federal Reserve responds to the actions in the marketplace!

When the market is in trouble, the Fed reacts by corresponding action…interest rate cuts and other forms of inflationary policies, thereby flooding liquidity into the financial system. Conversely, when the market recovers, US monetary officials technically siphon liquidity off by raising interest rates.

So the recent rate cuts translate to extant pressures or reflect bouts of turmoil in the marketplace.

As expected, the latent intoned subsidies by the Fed had been recently borne by the statements of Federal Reserve Vice Chairman Donald Kohn-policy must be nimble, flexible and pragmatic (Reuters)-and by Chairman Bernanke- ``renewed turbulence'' in markets may have shifted risks between growth and inflation” (Bloomberg) and the “Hope Now Alliance” (Bloomberg) or a pact with financial institutions to freeze interest rates.

These bailout expectations appears to have helped fueled the recent astonishing gains by the equity markets which we think could be more of a technical bounce.

Bottom line: In the decoupling debate, in appreciation of how US markets, the world’s largest and most sophisticated markets, have been influenced by its domestic policies, and thus, under the same prism we dare not dismiss the potential impact on the global financial markets by the corresponding actions that could be taken by major central banks.

Not even under today’s deepening trend of “financial globalization” which tends to increase linkages and therefore heighten correlations, will probably be enough to prevent markets from “decoupling” -in the sense that markets may perform independently or attain very low levels of correlation or dependency variables over the longer horizon. The distinct conditions of the underlying structure of the financial markets as well as the variance in the domestic currency regimes are likely to be the conduction channels for such marketplace divergence.

A Global Depression or Platonicity? II

``Our tendency to mistake the map for territory, to focus on pure and well-defined “forms”, whether objects, like triangles, or social notions, like utopias (societies built according to some blueprint of what “make sense”), even nationalities. When these ideas and crisp constructs inhabit our minds, we privilege them over less elegant objects, those with messier and less tractable structures…Platonicity is what makes us think that we understand more than we actually do.”-Nassim Nicolas Taleb

Projecting past performance into the future is a hazardous strategy. The recent fiasco in the US mortgage markets has been mostly due to such built in expectations of a perpetual boom.

Recalling ex-Citigroup CEO Chuck Prince’s infamous quip, ``When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing". That’s one pitfall which we stridently wish to avoid.

Thus, if a US hard landing scenario emerges where deflation or a severe credit “crunch” takes a firm grip on its markets and the economy, then the attendant monetary measures to be engaged by US authorities are likely to be aggressive (including the much ballyhooed Helicopter strategy by Ben Bernanke), considering their natural inclination to be averse to a Japan-like malaise.

As we earlier pointed out in our September 3 to 9 edition, [see A Global Depression or Platonicity?], the degree of exposure to tainted leveraged instruments in Asia has been limited.

And those advocating for a global meltdown could simply be overestimating on what they know and underestimating on what they don’t, and not giving enough room for randomness to operate, hence our tendency to “mistake the for territories” from which we cited Nassim Taleb definition of Platonicity.

As we also mentioned above, while financial globalization via integration of financial markets has the predisposition to increase correlations, different currency regimes aside from the divergent levels of development of the financial markets are likely to result to different outcomes in the face of such aggressive policy maneuvers.

For instance, considering that major currency reserve holders as China, GCC nations and Hong Kong, have effectively wrapped or surrendered their domestic monetary policies to that of the US by virtue of a US dollar peg, monetary policies are likely to have different impacts to their markets and economy compared to the US.

As Stephen Jen of Morgan Stanley splendidly wrote (highlight ours),

``The credit crunch we are witnessing is really a ‘rich’ countries’ problem. Much of EM (the GCC countries, China or Hong Kong) is unaffected and will not likely be directly infected by it. (We put ‘rich’ in quotes because on some measures some EM countries are richer in cash…) EM may eventually be adversely affected by an economic slowdown in the developed world, through trade, but not in terms of the credit cycle freezing up. In China, for example, the government has intentionally imposed a credit freeze, because it has too much liquidity. The same problem of excess liquidity is still faced by many other countries, such as Hong Kong, the GCC countries and some other EM economies.”

If the recent credit triggered market mayhem should serve as the proverbial canary in the coal mine then figure 4 courtesy of Rating and Investment Information shows how ASEAN Credit Default Swaps performed under the recent duress.

Figure 4: Rating and Investment Information: Narrowing ASEAN Spreads Indicator of Strength?

The cost of Credit-default swaps or contracts designed to protect investors against default has steadily narrowed since 2005 for ASEAN countries including the Philippines and Indonesia, the most vulnerable member countries of the region.

Yes, while there had indeed been a spike in CDS spreads during the August turmoil (encircled), it appears that these spikes can be discerned or construed as more of an “aberration” than of a reversal as the spreads appear to “normalize” or narrow anew.

Figure 5: IMF GFSR Report: Buyers of CDO (In percent, delta-adjusted basis)

As to further examine on the potential impact from the risks of the recent credit crisis turning into a full scale credit seizure, we can further estimate on the portfolio holdings by Asia of infected instruments as previously done.

Collateralized Debt Obligations (CDO) are investment grade structured finance products that are collateralized by asset backed securities, including subprime mortgages. The markets for these credit products have been heavily distressed following the string of losses brought about by the recent credit maelstrom, where estimated losses according to some analysts for the world’s biggest banks are at $77 billion with a potential to reach $260 billion (Bloomberg).

IMF’s latest Global Financial Stability Report as shown in figure 5 estimates that the bulk of the losses or those affected by these “toxic waste” products has been mostly from to the US.

According to the IMF (highlight ours),

``Direct exposure extends beyond the United States, with European and Asian investors active in the ABS and related markets. A handful of European institutions have already reported difficulties or closed owing to their exposure to U.S. mortgage markets and the withdrawal of their short-term funding, and still more are believed to be exposed to indirect mark-to-market losses stemming from their credit lines to conduits and structured investment vehicles. Within the Asia Pacific region, various market analyses suggest that exposure to mortgage-related products is concentrated in Japan, Australia, Taiwan Province of China, and Korea, but their overall exposure has been characterized as manageable and that region appears to be insulated from default risk.”

Figure 6: IMF GFSR :Probability of Multiple Defaults in Select Portfolios (In percent)

Figure 6 from the IMF’s GFSR likewise shows that among financial institutions large complex financial institutions (LCFIs) have been largely prone to losses reflecting extensive exposures to credit derivatives, whereas among emerging markets the estimated default risks remain “benign” with emerging Asia having the least risk.

From the IMF,

``Reflecting a weakening in credit discipline that has emerged along with the growth in credit, private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing, often embedding exchange rate risk or options and thus increasing their exposure to volatility. Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital market financing to help finance credit growth. Nevertheless, generally benign emerging market banking system default risk indicators continue to reflect market perceptions of healthy capitalization and profitability, as well as diverse earnings sources and sound asset quality. These trends warrant increased surveillance, as circumstances vary considerably across countries. Authorities in some emerging markets need to ensure that vulnerabilities do not build to more systemic levels. Across all emerging market countries, policies that support continued resilience should help, as global market conditions are likely to remain volatile.”

All of this simply reflects on the divergent exposures of different regions to the recent turmoil.

While we agree with the hard landing camp that trade or economic linkages are likely to affect global markets, where we part is the degree of impact. We don’t share the view of a global financial or economic meltdown.

Monetary policies even if even if they are to be ineffectual in the US are likely to impact the financial markets of different regions at varying degrees.

Given the inflationary tendencies of central banks, under the present Paper money standard, the most likely scenario will be a shift of bubble from one asset class to another, either to commodities or to Asian markets or both.

US Markets: Counting the Chickens Before They Hatch

This from CBSMarketwatch, ``U.S. stocks climbed for a second day Wednesday, with the Dow scoring its largest percentage leap so far this year, and a revived financial sector paving the way after a Federal Reserve official bolstered hopes for additional interest-rate cuts ahead.” (highlight ours)

This from New York Times, ``Stocks soared on Wall Street today after a top Federal Reserve official appeared to open the door for additional interest rate cuts, pledging to follow “flexible and pragmatic policy making” as the central bank decides how to cope with the current financial upheaval.” (highlight ours)

So aside from being oversold, obviously the US markets has been building its “bullish” foundations from expectations of further Fed Steroids or as they say "counting chickens before they hatch", this from Fed Governor Donald Kohn (emphasis ours)…

`` An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago. In general, nonfinancial businesses have been in very good financial condition; outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels. Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.”

…while ignoring hawkish comments from Philadelphia Federal Reserve Bank President Charles Plosser and Chicago Fed President Charles Evans or a case of "selective perception".

This only means that the FED has its hands tied, where it would need to appropriately respond to market’s expectations on December 11^th else risks a collapse. A confirmation from Bernanke’s speech tonight could add to these expectations.

Remember, two rate cuts of 75 basis points and a bunch of policy palliatives have recently failed to boost the markets, hence yesterday’s dovish statements from Governor Kohn. This could simply be a clearing rally from technically oversold levels and is no guarantee that markets would resume their uptrend over the interim.

Pervasive Losses In Global Financial Markets, US Treasuries Signal Rising Risk of Recession

``How, exactly, is enslavement won? Through a combination of fabricated “crises” and an insidious phenomenon known as “gradualism.” Create the crisis of your choice — global warming, education, Big Oil price gouging, home foreclosures … ad nauseam — then milk that fabricated crisis nonstop until gradualism is able to take hold and convince the brain dead that the only solution to the crisis is for government to step in and pass more laws to save us from imminent peril.” –Robert Ringer

AFTER two rate cuts (75 basis points), the opening of the discount window (including lowering of its rates), changing of some lending rules such as exempting banks to lend to broker subsidiaries and the widening of the eligibility of collateral acceptance and the injection of liquidity via repos and Federal Home Banks, where the US Federal Reserve appears to have utilized a panoply of monetary tools, including the unconventional ones, to cushion the impact of the housing recession triggered credit crisis, yet such dislocation continues to ricochet throughout the global financial markets.

Interest rates alone reflects on the recent stains where the “TED” spread or the difference between three-month US Treasury bill yields and Libor, the London interbank offered rate soared to record levels! We are thus witnessing a frenetic “flight to quality” in terms of a massive rally in US Treasuries, as shown in Figure 1.

Figure 1: stockcharts.com/ Ivan Martchev: Collapsing Yields of 10 Year Notes!

The last time US treasuries encountered such a colossal move was during the Nasdaq bubble implosion in 2000 that ushered in an economic recession. The blue horizontal arrow points to the closing prices of US the T-Note yields last Friday.

Don’t forget during this period, the US Federal Reserve slashed its Fed rates from 6% to 1% until mid 2003 in order to mitigate the economy’s deterioration but to no avail. Instead the ocean of US dollars generated consequent to such intervention has spawned a new monster; a US housing bubble buttressed by exploding leverage in terms of new financial instruments. Derivatives have now reached $516 trillion during the first half of 2007 (Bloomberg). And some of these are seen unraveling today.

Hence, the behavior of the US Treasury markets, relative to the speed and degree of its decline, suggests to us that a US recession is either imminent or now unfolding!

The impact of the credit crisis has apparently permeated to different sectors of the US economy from what we previously mentioned as signs of contamination in the commercial real estate to rising delinquencies in credit card, now globally to bond insurers (e.g Ambac Financials, FGIC Group, ACA Capital, French Natixis SA), reinsurers (e.g Europe’s Swiss Re), major mortgage lenders or “Government Sponsored Enterprises” (GSE’s) in Freddie Mac and Fannie Mae, Municipal Bonds (e.g. California’s downgrade) and even to rising incidences of default in US auto loans.

Mounting risks of losses from Australian and Japanese corporations loom on CDO downgrades, where recently major Japanese banks were reported to have accounted for ¥ 1.3 trillion yen or US $12 billion in US subprime exposure.

Even European banks have agreed to temporarily desist or suspend from trading on so-called “covered bonds”, or securities backed by mortgage or loans to public sector institutions (Bloomberg) `` to halt a slump that has closed the region's main source of financing for home lenders”.

Meanwhile, three month deposit yields in some Asian countries fell on contagion fears. This excerpt from Telegraph’s Ambrose Evans Pritchard (highlight mine),

`` The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety as investors across the region pull out of risky assets.

`` Yields on three-month deposits in China and Korea have plummeted to near 1pc in a spectacular fall over recent days, caused by panic withdrawals from money market funds and credit derivatives…

`` Korean and Chinese three-month yields have fallen from 4pc to 1pc in a matter of days in an eerie replay of events on Wall Street in late August when flight from banks and the US commercial paper markets caused yields on three-month Treasuries to falls at the fastest rate ever recorded. Asian investors appear to be opting for deposit accounts with government guarantees.

`` It is unclear what prompted this latest "heart attack" in the credit system, though rumours abound that Asian banks have yet to own up to their share of the expected $400bn to $500bn losses from the US mortgage debacle.”

Even sovereign debts appear to be stomped by the ongoing stampede out of risk assets, from Financial Times (highlight ours),

``Investors are shunning European government debt issued by countries other than Germany as worries about a global economic slowdown prompt a flight to safety within Europe.

``There is a strong sell-off in sovereign debt relative to [German] bunds, ranging from top-rated Spain to eastern Europe,” said Ciaran O’Hagan, strategist at SG CIB.

``Credit spreads, derivatives, and currencies are all taking a whack as part of the flight to quality.”

These developments include emerging market debts which this week suffered quite heavily. Curiously, while most of the damages to emerging Asian debt had been relative to domestic currency denominated issues, the Philippines appears to have been the least affected in both local and US dollar issues, based on the data from Asianbondsonline.org. Of course this is not to suggest that we are “better off” than the rest of the pack, as one week does not a trend make.

Japan In “Bear Market”, Will Global Equities Follow?

``The ultimate driver of Japan’s adaptation today is globalization. In short, the world changed while Japan slept, as more and more developing countries became participants in the world’s economy and the old patterns of trade and capital flow went by the wayside. Now, as Japan reawakens, its challenge is to find a place in this different world, starting with its own backyard: Asia.”-Matthews Asian Fund

Figure 2: Stockcharts.com: Are Global Markets Headed Lower?

Major equity markets continues to be in a funk with Japan’s 39-year old broadest benchmark, the Topix, technically entering into a “bear market” when it declined below the yardstick of 20% from its 2007 peak last week. The Topix is down by over 21% as of Friday’s close. (Thursday to be exact-Friday was Labor Thanksgiving “kinro kansha no hi” holiday)

Another major Japanese equity bellwether, the Nikkei 225, a price weighted index of Japan’s top 225 blue chip stocks, as shown in the main window of Figure 2 courtesy of stockcharts.com, has been down by nearly 19% and is clearly approaching its pivotal support level at 14,000.

Meanwhile, Europe’s Dow Jones Stoxx 50 or (stoxx.com) a ``leading Blue-chip index for the Eurozone, provides a Blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain” have lost about 9.5% from its peak (shown in the upper pane below main window) and like the Nikkei 225 seems to be testing its critical support level at around 3,500.

The broad based S & P 500 (pane above main window), a major US bellwether, is down by about 8.6% from its peak, relieved from its recent lows by a stern rally last Friday, but on lean volume, on an abbreviated trading day following the Thanksgiving Holiday. Incidentally, the Dow Jones Industrials has touched the 10% loss trigger point which should activate the next phase of the “Bernanke Put” this December 11^th.

Like the Nikkei and the Dow Stoxx 50, the S & P 500 is nearly at the cusp of the crucial threshold level at 1,400.

On the other hand, the Dow Jones Asia Pacific ex-Japan stocks (lowest pane) surrendered about 14% of its gains from the recent highs and appear to be in a pronounced decline reflecting the same activities in the major markets.

From Bloomberg (emphasis ours), ``Global stock markets have lost $2.9 trillion since Oct. 31 and the collapse of the subprime market in the U.S. has triggered about $50 billion in writedowns among the world's largest banks.”

So, in a break from last week’s seeming indecision, global markets appear to be signaling in unison a forthcoming test of the respective critical support levels, which may determine the direction and returns for 2008.

With the recent performances of the US treasury markets indicative of an approaching US economic recession, plus Japan’s likely transition towards an interim bear market, the likelihood is that once these levels have been cleared, a “bear market” could be the hallmark of global equities in 2008, unless of course we see an elaborate turnaround soon.

A US Recession Will Initially Drag Global Equities Lower

``Recessions are not caused by a general shortfall in spending, but instead by a mismatch between the mix of goods and services supplied by the economy and the mix of goods and services demanded. Though demand shifts away from some kinds of output that the economy produced in the prior expansion (as we saw with tech and telecom in 2000-2002 and are seeing in housing today), we often see continued demand in other sectors, but the mismatch takes time to correct, and output and employment suffer as a result. Most job losses during a recession are typically concentrated in a small number of industries, while other industries experience growth and even growing backlogs and rising employment. So the next recession, whenever it occurs, will probably feature a good amount of dispersion. Most likely, we'll observe particular weakness in housing-related industries (and associated finance sectors), while a variety of sectors including technology, oil services, broadband telecommunications, and consumer staples may be better situated (though such stability still may not prevent stock price weakness).”- John Hussman, Hussman Funds

How does a US recession affect world equity markets?

Learning from the past using the 2000 model we can take note that global equity markets echoed the directional path of the US markets as shown in figure 3.

Figure 3: US 2000 Bubble Implosion Reverberated in Asian Markets

Where the US Tech bubble crashed in 2000 as shown in Figure 3 (see red line), the plight of the Philippine benchmark, the Phisix (shown by the black candle), which was in a bear market in the aftermath of the 1997 Asian Crisis, was further aggravated until it reached its trough in 2002.

The 1998-1999 cyclical rally amidst a secular bear market was mostly due to the reaction as a natural consequence to the violent 1997 selloff and in confluence to the seasonal “New President’s stockmarket honeymoon” following the Presidential election victory of Joseph E. Estrada.

As you can see, no trend goes in a straight line. And secular trends are usually pockmarked by intermittent cyclical countertrend movements or plainly said, a cyclical bear market amidst a bullmarket or a cyclical bullmarket amidst a bearmarket. 1998-1999 signified the latter.

Notice too, that Asian markets represented by Japan’s Nikkei (green line), Hong Kong’s Hang Seng (gold line) and Singapore’s Strait Times (blue line) all turned lower or inflected by 2000, stayed on a general declining trend for more than a year then bottomed out synchronically by 2002.

So if the past were to do an asymmetric reprise, then a US recession could likely lead to a similar decline in Asian markets, including our Phisix…initially.

Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?

``The more creative we get, the wider the diameter of our searchlight, the less likely we are to get blindsided. More things can happen than will. But more things will happen that we don’t expect. The best thing of all: tomorrow’s headlines will be full of interesting things that nobody could have ever predicted today would happen tomorrow.”-Josh Wolfe, Forbes Nanotech

Of course the debate about decoupling is mainly semantics.

Similar to the polemics of Market Failure premised on imperfect competition, some of such arguments are noticeably fallacies predicated on absolutes. Since a country has interactions with other nations (even communist countries) then linkages results to connections or correlations, which varies on the scale or degree of transactions involved. Since under such context, there is hardly anything as a perfect correlation, there would likewise be no perfect decoupling.

Since today’s globalization trends translate to increased collaboration through trade or financial channels, this should extrapolate to more linkages, thus heightened correlation. So, the argument of decoupling essentially boils down to its definition.

Decoupling defined in the economic context (wikepedia.org) ``refers to the lessening of correlation or dependency between variables.” (highlight mine)

In the financial markets, our observation is that decoupling is basically measured in the context of correlations of price trends among securities or markets.

A trend maybe said to be positively correlated when there is a (answers.com) ``Direct association between two variables. As one variable becomes large, the other also becomes large, and vice versa. Positive correlation is represented by Correlation Coefficients greater than 0”. (highlight mine) The movement of Asian markets relative to the US markets in 2000-2002 is an example of strong positive correlation.

A trend maybe said to be negatively correlated when there is an (answers.com) ``Inverse association between two variables. As one variable becomes large, the other becomes small. Negative correlation is represented by correlation coefficients less than 0.” (highlight mine)

My favorite example would be that of Zimbabwe, an African country that has been on sordid streak of economic, political and social despondency, as discussed in our April 9 to 13 edition, [see Zimbabwe: An Example of Global Inflationary Bias?]. The country’s inflation rate has incredibly soared to stratospheric levels at 14,841% (Bloomberg) in October albeit its stock markets continue to fly! Now relative to the correlation between economic health and stock performance then it can be said that Zimbabwe’s case signifies negative correlation or a decoupling.

Or let us take another example in Saudi Arabia’s major equity benchmark the Tadawul, shown in Figure 4, as a representative for Gulf Cooperation Council (GCC) whose other members include Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (UAE), where most of Gulf member bourses have been on an uptrend.

Figure 4: Bloomberg: Saudi’s Tadawul: Recovery Amidst Global Decline, Will it last?

We dealt with the potential “bottoming” of Saudi’s benchmark last May 28 to June 1, [see Could China’s Bubble Last Longer than Expected?], today the GCC bourses appears to have “defied gravity” or “decoupled” or has been “less correlated” relative to the ongoing global infirmities among its counterparts.

Our suspicion is that speculations on the fate of the GCC’s extant dollar peg (except Kuwait) which has resulted to greatly enhanced inflation pressures have been the primary driver of this seeming recovery. You see, the feasibility of the US dollar peg is now being questioned as the US dollar continues to fumble.

Investors appear to bet on the unplugging of the US dollar peg soon, where GCC member countries would be compelled to revalue their currencies to the upside. Hence, the expected strengthening of the region’s currency has provided incentives for investor to bid up on GCC equity assets. Again, expectations on monetary policy adjustments almost similar to the thesis underpinning China have become crucial drivers to global capital flows.

This excerpt from the Economist magazine’s recent article “Time to Break Free” (highlight mine) underscores our analysis,

``Nowhere are the dilemmas more acute than in the Gulf, where virtually all the oil-rich states peg their currencies to the greenback. The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation. When the Gulf states meet on December 3rd in Qatar, they should agree to loosen their ties to the dollar.

``The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff.

``Soaring oil prices have brought the Gulf Arabs huge riches. Their real exchange rates, as a result, ought to rise. The simplest way to do that is for the currency to strengthen, but the peg prevents nominal appreciation. Worse, the dollar itself has been falling. The result is rising domestic inflation. Some smaller Gulf economies now have inflation rates of around 10%...

``A big uncertainty is what such a shift would mean for the dollar. In the short term, the effect on the Gulf states' appetite for greenbacks would not be dramatic, since the dollar would have a big weight in any basket. And there should not be a sudden sale of the oil exporters' dollar reserves. The worry is that the end of the Gulf states' dollar peg would send jittery investors into a panic. That risk is real. But with oil prices rising and the dollar falling, the dangers of inaction are greater. The Gulf states need to get rid of their dollar peg now.”

So while decoupling critics rightly argue that financial market activities could reflect on the technical economic, financial and trade interactivities that may result to higher correlation, one very important undefined outcome is how financial markets would react to forward monetary policies in response to today’s tensions which could affect the mobilization of money flows. As a Wall Street axiom goes, money flows where it is best treated.

Or will today’s financial market’s turmoil lead to a meltdown of the financial system as some would suggest, and thus pave way for a global deflationary depression scenario?

We doubt so, since the degree of exposure to the present systemic leverage cannot be applied similarly to all regions/countries ergo the relative effects will be different.

As an example the Philippines with its primordial markets have an infinitesimal degree of derivatives exposure compared to the US, so how can the effects be the same? While a recession in the US may affect trade, remittances or capital accounts and result to an economic growth slowdown, deflation is unlikely to happen since there has not been much debt built into system following the Asian Crisis. Moreover, our government is likely to undertake more inflationary policies on the account of “voter” demands.

Our favorite guru Dr. Marc Faber thinks such “deflation” scenario as unlikely. Dr. Faber writes (emphasis ours),

``With the propensity of the Fed and the ECB to flood the system with liquidity and to take “extraordinary measures” whenever problems arise, deflation is a remote possibility for the foreseeable future.

``So, before worrying about deflation, I would worry about inflation accelerating strongly in the years to come — especially if the US economy stagnates. But let us assume that at some point in the future deflation follows. What then? In my opinion, deflation could only be triggered by one event: a total collapse of the existing global credit bubble. And the only event I can think of that would trigger such a debt collapse would be a third world war. The failure of a large bank — say, Citigroup — wouldn’t do the trick, because the Fed would immediately bail it out (unless Ron Paul is US President).

``Now, in a debt collapse, where would you rather have your money? In bank deposits, in CDs, in dubious commercial paper, in bonds, in money market funds — all of which would experience soaring default rates — or in physical gold, ideally in a safe deposit box? I think that, particularly in a debt collapse, physical gold would shine, as people the world over would become extremely concerned about, not the return on their money (interest), but the return of their money. This would be particularly true of Asian central banks, which now have less than 2% of their reserves in gold but hold massive quantities of all kinds of debt securities.”

Now could the prospective easing policies initiated by global central banks alleviate the pains of today’s gridlock in the financial system or preclude a crisis?

It depends, as Austrian Economist Frank Shostak explains, ``As long as the percentage of wealth generators as a percentage of all acting individuals is still large enough Fed policy makers can get away with the policy of “rescuing financial markets”. However if this percentage falls to below 50 per cent then there is not going to be a sufficient amount of real savings to carry all the activities in the economy, a deep economic crisis emerges.”

As you can see conventional impressions or deductions can also be misplaced.

Figure 5: Rude Awakening: Emerging Markets Priced Safer than US Financials

Another example--Who, in the past, would ever discern that the biggest US financial companies would be perceived as “riskier” than emerging market bonds?

The cost of insuring US financial companies as exemplified by Merrill Lynch has become unbelievably higher today than Brazil’s sovereign bonds as shown in Figure 5. The chart likewise shows that the cost of Brazil bonds has painstakingly been on a downward trend overtime, which suggests of signs of strength rather than luck.

Eric Fry of Rude Awakening writes (emphasis ours), ``Buying five years of protection against a Brazilian default used to cost much more than buying five years of protection against a Merrill Lynch default.

``But now that Brazil has become as crisis-free as the U.S. financial sector has become crisis-prone, CDS prices have flip-flopped. Merrill CDS prices have jumped above those for Brazilian government debt! In other words, CDS buyers consider a Merrill Lynch default more likely that a Brazilian default.

``Maybe CDS investors have got it all wrong...or maybe the U.S. finance sector is in much deeper doo-doo than most investors believe. The "doo-doo" interpretation seems more plausible.

``CDS pricing is not necessarily indicative of future trends, but neither is it NOT indicative...Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance...”

While past performances or activities may have relative predictive value to future outcomes, they may not be so linearly correlated.

Plainly said, past performance may indicate future trends, but then again they may not. So under such premise, if today’s “safer” emerging market bonds become a definitive future trend, then these could be reckoned as signs of “decoupling” from past patterns, where investors would opt for emerging market assets than for US “riskier” dollar denominated assets. Otherwise, present trends could merely be indicative of an aberration, meaning a temporary phenomenon.

Differences of Tech Bust 2000 versus Credit Crisis 2007: US Dollar, Gold and Oil

``Throughout the 1980's and 1990's, all Asian asset classes had been highly correlated, highlighting Asia's status as an emerging market. However, since the late 1990's, Asian bonds, equities and currencies have "decoupled" as Asia took on the attributes of more developed markets.”-Gavekal Capital

This brings us to the last factor, the important distinction between the implosion of the Tech bubble in 2000 and today’s financial markets as shown in Figure 6, courtesy of economagic.com.

Figure 6: Economagic: Important Differences between Today and 2000: US dollar, Gold and Commodities

In figure 3, we showed that the US Technology bubble crash and the attendant economic recession dragged the Asian Markets along with it.

However, during such period, there had been some noteworthy nuances seen in the light of the trade weighted US dollar (red line), which had been in steady ascent until early 2002, while in contrast gold (green line), energy (gray line) and general commodities (blue line) were all in descent and gradually bottomed out at the twilight of the recession (shaded area) or in late 2001.

Meanwhile, today’s scenario has been in stark contrast, so far; falling equity markets and sharply rallying treasuries are seen under the backdrop of a LIFETIME low US dollar index, HIGHEST EVER oil prices and Record HIGH Gold prices as well as surging commodities. So relative to 2000, these signify signs of decoupling.

So what does this imply?

This suggests that what transpired in 2000 may not be exactly the same today.

If present price trends continue, then oil, gold and other commodities effectively “decouples” from its previous patterns. And so goes with the US dollar. Inflation and not deflation will be the cause of concern.

Of course, it may turnout that the decoupling critics could be right and recent trends could reverse, but for the present being, the burden of proof lies with these critics more than what price trends in various asset markets have been telling us.

It also implies that if the US dollar, gold and oil are responding to the anticipated changes in monetary policies, then the possible ramifications to other segments of the financial markets could be directed by similar predicate, anticipated changes in monetary policies.

It is from such grounds, we borrow the legendary oil and gas executive, T. Boone Pickens, line of forecasting, that the Phisix could backtrack to 2,800-3,000 before reaching 5,000 over the medium term, with 10,000 over the longer horizon.

Thanksgiving or Turkey Day Message: Private Ownership and Free Markets

Americans today celebrate Thanksgiving day. Elliott Wave's Marketwatch tell us the reason why...

"The history books have it right in describing the Pilgrim's first harvest in 1620 as meager, followed by a miserable winter. It's also true that help from nearby Native Americans made for a better harvest in 1621, which led the Pilgrims to celebrate the Thanksgiving feast we all learned about as children.

"Yet here's the little-known part of the story: The harvest in 1622 was another failure, to the point that the remaining Pilgrims faced starvation. Why? Because during their first three years, these Pilgrims practiced "farming in common." The farmland belonged to the colony, and so did the food; portions were rationed out.

"So in the spring of 1623 the Pilgrims decided to take a calculated risk. They allocated individual plots of land for ownership among the families and members of the colony. In turn, each of the new owners was responsible for their property and for what it reaped.

"I'm sure you can guess the outcome of private ownership and individual incentives. The harvest in 1623 was plentiful -- and that was the year when the Pilgrims chose to set aside an annual day of thanksgiving to God. In a few short years, the colony produced abundance beyond its needs, and it was equipped to begin trading the surplus. They considered this turn in their fortunes to be miraculous; with the benefit of hindsight, what they had discovered was the miraculous benefits of private ownership and free markets."

Amen.

The Economics of Philippine Election Spending

``The bottom line is that political campaigns are really good for the bottom line, especially the bottom line of media outlets. They are also great news for fans of wealth redistribution: campaigns take money from wealthy contributors and spread it around to everyone else.”-Stephen Dubner, Freaknomics

In a recent social gathering I attended, the topic of election spending was raised where it was attributed as an important contributor in today’s systemic “corruption”.

The commonly held view is that since the costs of getting elected continues to rise with each political exercise, any seeker of a public office would naturally attempt to recover from the attendant expenses incurred during the campaign and possibly profit from the position, mainly through from kickbacks via the Pork barrel or through other illegal or covert activities.

While of course, we do not dispute the inferences of causality that “expensive” elections most likely leads to corruption, what we believe is thoroughly missed by such argument is the economic dimension from which the whole cycle was brought upon in the first place. In our view, such exposition deals with only the symptoms but glosses over the genuine causes.

So why would any politician be so intensely keen with the so-called Pork Barrel? Dealing with basics is paramount for our wider understanding, from which we ask…what then is a Pork Barrel? According to Encarta Dictionary, it is ``government projects affording political opportunism: government-funded projects that bring jobs and other benefits to an area and give its political representative the opportunity to award favors and reap the ensuing prestige” (highlight mine). Thus, Pork barrel is nothing more than Spending of Other Peoples Money (SOPM) at the discretion of an “elected” political representative.

In other words, Pork barrels are essentially meant as political financed solutions to the social problems (mostly economic) within the jurisdiction of a political representative. This also means that such power to redistribute wealth is “ideally” intended to address the needs or concerns of their constituents but, as Encarta describes, ends up serving other (self serving) purposes than originally intended.

Since the “cost” of getting elected has become pricier, then naturally such premise implies the basic economic concept of demand and supply at work.

The economic framework: Since the demand for political solutions to the nation’s social problems increases, then the functions of political wealth redistribution has to be accompanied with necessary increases in funding (print money, borrow or tax) and logistics via more bureaucracy (more personnel, police power, office equipments etc…). Remember, fundamentally each enacted law corresponds to additional costs. Why do you think the Philippines’ fiscal budget for 2008 has now ballooned to P 1.227 trillion, a 9% increase from last year? And since the supply for public positions that are bestowed with the power to redistribute wealth are limited then naturally the price of getting elected over such political jurisdiction increases!

Plainly said, when we demand for more social spending or welfare based programs to resolve our problems then we increase the funds allocated to politicians for their dispensation. Essentially, Pork Barrels signify our excessive dependence on government where the correlation of government spending and the price of getting elected are direct.

Now whether or not politicians “honestly” fulfill their missions, the main problem is that most redistributive wealth “subsidies” programs are inherently non productive and capital consuming, (e.g. massive “pump priming” by Japan in the late 90s failed to lift its economy out of the “lost decade” rut which instead resulted to a 160% public debt to GDP whose credit rating is now even lower than Africa’s Botswana! Talk about the theoretical feasibility of pump priming and its multiplier effects, duh!), which leads to more distortions in the economy, lower competitiveness, lack of investments, greater inequality, and therefore a more vicious inflationary cycle, which will be eventually felt through a higher cost of living in the future.

Is there any incentive for the incumbent politicians to reduce this? The answer based on cost benefit analysis is most likely a NO. Why? Because for most of the politicians, more power means more control over the system and its constituents which translates to more PERSONAL benefits, either economically or egotistically. Why should the politician give up on these all benefits? Think reduced bodyguards, diminished social status or privileges, as cars, overseas trip etc... Instead, the logical direction is to even look for more social programs or for more social dependence on them that would justify increased funding and the coincident discretionary spending power that comes with it. And social welfare dependency is what mainstream media promptly emphasizes. In short, we solve inflation with even more inflation!

So when we blame politicians for being “corrupt”, we are thus implicitly blaming ourselves simply because we empower them to do so by the provision of the disproportionate power over our resources and to our actions, as well as the opportunities to “corrupt”, in the name of public weal or in solving each and every aspect of our daily problems, when in most instances these politicians are reactive (policies based on popular short-term demands), biased (penchant to favor the interest or interest groups whom they understand more or are familiar with) and most importantly unmindful of the unintended consequences of their actions (who pays for policy mistakes? Not them but the people). As Ludwig von Mises wrote in Economic Policy ```Once you begin to admit that it is the duty of the government to control your consumption of alcohol, what can you reply to those who say the control of books and ideas is much more important?”

In effect, the Philippine political system which institutionalizes the Pork Barrel as a political “social” solution is in itself institutionalizing the venal patron-client or the patronage system which continues to serve as a major hindrance to our development. We tend to always look at personalities or at superficialities mostly fed by mainstream media when the problem is the system. That’s why personality based solutions are most likely to fail, since we do not deal with the causes but only with the symptoms and thus end up perpetuating the game of musical chairs. Again, we never learn.