Global Depression: A Theory Similar To A Horror Movie?

``We citizens will remain pessimistic about the future. That’s our way. And that pessimism is exactly what we need to drive the technological advances that will bring the Golden Age. If we trusted the Golden Age to come on its own, it wouldn’t. It will take a lot of work. Luckily, that work is happening.”-Scott Adams, Dilbert

My daughter likes to watch horror movies. Her past problem was that each time she watches these, fear gets to overwhelm her such that she won’t be able to sleep or stay in a room by herself. This requires my presence at her side. Thus, each time I encounter her watching such genre of shows, I constantly remind her that “these are only movies” or that screenplays depict on the plots engendered by the film producers to entertain viewers.

Logical Fallacies and the Ludic Fallacy

Many analysts limn today’s investment landscape like a horror movie. They predict that the world will segue into a deflation induced global depression-your financial world Armageddon. Their simplified basic premise as follows:

The US is undergoing a “deflationary spiral”
Since the US functions as the most significant economic growth engine to the world
Hence the world will also fall into a US led-deflationary depression.

While their arguments or what we call as the Dry Bone deduction (toe bone is connected to the ankle bone is connected to knee bone…) presents a compelling case, we share Nassim Taleb’s dyspathy towards Mental Mapping. To quote Mr. Taleb from his magnum opus, The Black Swan (emphasis ours) ``We worry about those that happened, not those that may happen but did not. It is why we Platonify, liking known schemas and well-organized knowledge-to the point of blindness to reality. It is why we fall for the problem of induction, why we “confirm”. It is why those who “study” and fare well in school have a tendency to be suckers for the Ludic Fallacy.”

Further, such arguments seem to fall under logical fallacies of “begging the question” and the fallacy of “division”.

Begging the Question is (nizkor.org) `` a fallacy in which premises include the claim that the conclusion is true or (directly or indirectly) assume that the conclusion is true. This sort of "reasoning" typically has the following form”. Or essentially, an argument whose conclusion is its basic premise.

Meanwhile, the fallacy of Division (wikipedia.org) ``occurs when one reasons logically that something true of a thing must also be true of all or some of its parts.” Or the belief that the US equals or is the world- via the basis of tight interdependence.

The basic premise that the US financial system is presently undergoing a credit contraction, which is defined as deflation, is quite accurate. However, the assumption of the trajectory of its present activities will be transmitted to the world through the linkages of trade and finance is highly questionable in our view.

Moreover, depression advocates could be overestimating the inferred impacts of such linkages and at the same time underestimating the potential effects of government actions. This is not to suggest government actions will succeed which we think will not. Instead government actions out of the political demand to mitigate any crisis or dislocations could lead to unintended consequences.

While we fundamentally agree that every credit driven booms eventually result to catastrophic busts, we find the intense obsession towards the paradigm of Japan’s “lost decade” or the 1929 depression as undeserving.

Mistaking such maps or models for reality is what Mr. Taleb describes as the “Ludic Fallacy”.

Analyst Viewpoint: Rearview Mirror or Windshield Outlook?

The fact that the mortgaged induced securitization-derivative implosion has roiled some major developed markets and economies today should not extrapolate that the rest of the world will follow the same path.

For instance, as we pointed out in our previous issues the Philippines have little exposure to such toxic wastes; missed out entirely the recent global real estate boom (see Figure 1), have been reducing its debt levels (public and private), have seen its forex reserves surge in consonance with its Asian neighbors, a belated upsurge in the Peso and saw its stock market up by only about 260% during the past 4 years-which is hardly symptomatic of a bubble.

Figure 1: ADB Bond Monitor Real Estate Loans as % to Total loans

Besides, our belated reaction to the property boom appears to be cyclical; it took years to cleanse out the malinvestments in the system following the Asian Financial crisis.

Yes, a hard landing in the US will surely impact the world but to a different degree than the depression advocates have been projecting.

Next, previous crisis have shown different impacts to global markets.

Figure 2: Select Global Markets: A Rendition of Past Performance?

Figure 2 shows of the different equity benchmarks over a 20-year time frame. The Philippine Phisix (Green), US S & P 500 (black), Japan’s Nikkei 225 (blue), Hong Kong’s Hang Seng (violet) and Brazil’s Bovespa (red).

Our intention is to show how markets performed during the previous crisis in parts of the globe and its interrelation with other markets.

Depression advocates have been deeply enamored with Japan’s bust as a model, yet in 1990, the sharp drop in the Nikkei (blue top) has not impacted significantly much of global markets. In hindsight, one may argue that given the nascence of financial globalization and lesser trade or financial linkages by Japan’s economy relative to the world, a slump in Japan’s economy and markets had not meaningfully been transmitted to the world.

In fact, what transpired appears to be a shift-a boom in ASEAN markets and economies, represented by the Phisix and in Latin America, represented by Brazil.

The boom in ASEAN had been corollary to massive Japanese direct investments seeking out low cost production cost as an offshoot to the 1985 Plaza Accord, aside from hefty portfolio flows from US, first generation Newly Industrialized Countries of Asia (Taiwan, Korea, Hong Kong) and other foreign based funds in search for higher yields. As with all credit driven booms, following Latin America’s Tequila Crisis and the Asian Financial Crisis, ASEAN and Latin America equity benchmarks collapsed.

As Asian markets wobbled from the double whammy of Japan’s collapse and the ASEAN bubble implosion, what transitioned was a boom in the US led the technology sector or that global fund flows found its way into the US markets.

The dot.com bust in 2000 was the first concrete manifestation of synchronized markets (blue arrow and left light orange vertical line) as the Phisix, Bovespa, Hang Seng, Nikkei and the S&P all suffered declines but varied on the degree of losses.

Following the erstwhile Fed Chair Alan Greenspan’s drive to forestall the menace of “deflation”, the Federal Reserve slashed its rates to a 60-year low at 1%. Such policy actions stoked a reversal (blue arrow and rightmost light orange vertical line) in favor of the bulls, which saw diverse asset classes (bonds, stocks, commodities, collectibles-paintings stamps wines etc.., real estate) across the globe markets soar in near simultaneous fashion.

Thus, global depression advocates appears to have “anchored” their analysis using the recent past performance of tight correlation (in 2000-2006) as their basis for forecasting a global gloom and doom scenario. Such recency based analysis is called by Warren Buffett as the Rear View Mirror syndrome, to quote the Sage of Omaha, ``In the business world, the rearview mirror is always clearer than the windshield.”

Windshield Outlook: NO Signs of Global Depression Yet

Now looking at the windshield we ask, what has transpired so far over the decades was divergent markets which eventually evolved into convergent markets…our $64 trillion question is, will the past performance do a reprise?

As an aside, I am guilty of the same mistake of interpreting past performance for future outcome last year. When the first symptoms of the mortgage-securitization crisis appeared, I initially panicked out of the thought that local investors, who remained subordinate all throughout this cycle or since 2003 until mid-2007, would not provide for sufficient volume enough to match the equivalent intensity of foreign selling, hence increased the risks of a market collapse. Although, I expected local investors to pick up their volume eventually as we argued in 2006, the lack of consistent material evidence during the boom since 2003 rendered me a skeptic on the locals’ capability to shore up the market especially under duress, thus, the misread.

Nonetheless, 2007 proved to be the first instance where local investors proved their moxie, which again as discussed last week, should be a bullish underpinning. Once the sentiment of foreign returns in our favor, bullish locals plus bullish foreign money should propel the Phisix much higher! But, again, the ultimate question is one of timing-when will foreign money will reverse their sentiment?

As we all know, 2008 has started out negatively, with most major global equity markets suffering from the knock on effects of the credit triggered turmoil in the US financial markets.

While the impression portrayed is that the world is presently “recoupling” based on the woes of the US, we do not want to succumb to the fallacy of being blind to the “reality” that some markets appears to be in fact, “decoupling” from the US as shown in Figure 2. We will follow Warren Buffett’s advice of focusing at the windshield.

Figure 3: stockchart.com: BRIC countries Recoupling or Decoupling?

Figure 3 shows us that even while major developed markets have seen their equity benchmarks in a downdraft, contemporary benchmarks of major emerging market protagonists categorized as the BRIC or Brazil, Russia, India and China have still been ascendant if not remain at elevated levels in spite of the recent bouts of credit driven financial market tremors. This prompts us to ask; are the BRICs “recoupling” or “decoupling”?

As we have repeatedly mentioned, deepening financial globalization trends effectively works to integrate various economies through trade and financial mechanisms. Put differently, in today’s globalization trends markets and economies are likely to have greater degree of interdependence relative to the past, hence any shock could impact countries varying on the depth of their exposure to such trends.

But the important caveat is that countries are structured differently in terms of trade, financial markets, economies, fiscal and monetary policies and governance such that there is no such thing as a perfect correlation or integration. Such distinctions matter a great deal.

I have repeatedly used Zimbabwe as an example. Zimbabwe suffers from consecutive years of economic recession (unemployment rate at 80%, 30% contraction of GDP over the past seven years-voanews.com) which has resulted to a hyperinflationary depression-with present inflation raging at 24,000% (earthtimes.org), prompted by political repression. But guess what? Despite the standstill in its economy, where businesses appears to have grounded to a halt, its stock market soared by an astounding 300,000%, particularly 322,111% in 2007!

Why? Because of government policies. The argument is not about the size of its economy but rather how government policies influences markets or economies. It’s not your run-of-the-mill narratives impelled by economic or corporate forces as most analysts or experts suggest. It’s about the unintended consequences of government policies or activities on the marketplace and the economy. The shriveling value of the its currency, the Zimbabwe Dollar, effectively translates to a functional loss of its monetary role of “store of value”. Thus, the currency’s negative yield or the effective loss of purchasing power prompts for a substitute or a search of value greater than the currency-found in the form of company stocks.

As Ludwig von Mises in his Theory of Money and Credit observed (highlight mine), `` …a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time.”

This brings us back to our earlier assertion that monetary policies adopted by the US Federal Reserve pumped up prices of diverse asset prices across the continent; if monetary policies influenced global assets in the past can they not influence in the same manner global asset policies at a dissimilar scale?

Depression advocates insist that no, fiscal and monetary policies will end up in the same route as the Japan experience.

Here is a monumental quote from Treasury Henry M. Paulson, Jr. during a speech at the Asian Society last December 5 (highlight ours), ``Some in China are suspicious that the U.S. push for RMB appreciation and financial market liberalization is really an attempt to gain trade advantages and generate profits for American companies while slowing China’s economic expansion. They mistakenly believe that yen appreciation during the mid-1980s caused Japan’s weak economic performance in the 1990s. Rather, we now know that Japan’s economic difficulties were caused by the growth, and then collapse, of a huge stock and property price bubble, and the failure to use monetary policy to prevent the emergence of deflation after the bubble burst.”

Or how about this from Fed Chairman Ben Bernanke’s recent speech (New York Times), ``We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”. (highlight ours)

See what I mean? US authorities are in the belief that “appropriate” policy responses will serve as the much needed elixir to its present strains, and would act accordingly.

Now of course, the bag of tricks with which they intend to utilize could be expected to be far more than the traditional tools than we know of, given their understanding of the inadequacy of Japan’s policy responses (ZIRP, Quantitative Easing, massive pump priming).

Bernanke’s Helicopter speech is just a manifestation of the unconventionality of instruments they are willing to experiment with. Some of the recent examples of the new policy responses applications, the Term Auction Facility (TAF), Federal Home Loan Banks, aborted Super SIVs, swap agreements, changes in procedural rules and collateral and lending policies and others.

The point being that the future actions by US authorities will depend on its tolerance to meet the political demands of the whimsical voting public. In an election season, the inclination is to be more accommodative. However if conditions turn for the worst, where authorities will reactively pan to the public’s outcry for the mitigation of their economic or financial woes, then Bernanke’s hyperbole expression of turning to “helicopters” may be realized but in different forms, possibly through a cocktail of policy responses such as outright subsidies or bailouts, nationalization, price controls, capital controls, increase in borrowings to fund more welfare projects, increase government hiring, taxes etc.. Desperate measures for desperate times.

And upon such actions will correspond to the unintended consequences in the US and elsewhere abroad, where the transmission channel should mainly be through the US dollar- as the world’s reserve currency. Thus, the impact from such policy responses is likely to be divergent.

In the ASEAN region its equity markets have responded divergently too, as shown in Figure 4.

Figure 4: stockcharts.com: ASEAN Markets: Recoupling or Decoupling?

While the Philippine Phisix and the Thailand’s SETI appears to follow the actions in the developed world which means that they have been falling too, Indonesia and Malaysia’s markets have amazingly turned higher. In fact, Malaysia’s stocks, signified by Dow Jones Malaysia Stock Index (upper pane) appear to have shifted into an overdrive following its significant breakout last week on the account of heavy foreign buying (Reuters).

Don’t ask me for particulars why foreign money has started to prop up these benchmarks, I have nary an idea. Nonetheless, what we understand is if ASEAN is “recoupling” with the US then eventually the outliers or the present winners will reverse to reflect the path of the US markets, but if the present “decoupling” trend will be reinforced then we think that the Phisix and Thailand’s SET will likely follow the direction of this year’s leaders. As you know a decoupling strengthens our outlook for a Phisix 10,000 on a backdrop of surging Asian markets.

More to the point, if one looks at equity flows during the 2007 financial maelstrom, data from emergingmarketportfolio.com tells us why ASEAN or BRIC countries remain at lofty levels as shown in Figure 4.

Figure 5: courtesy of EPFR Global: Emerging markets as Safe haven?

In the past, we have shown you how some emerging market debt instrument have shown lower yields (priced on the basis of lesser risks) compared to that of US financials where the implication is that emerging markets have now become some sort of a “safe haven” [see November 19 to 23 edition, Decoupling Debate: How Forward Monetary Policies will Affect Financial Markets?]

Figure 5 from EPFR shows (right pane) how Dedicated Emerging Market Funds and International Global Markets have attracted capital flows at the expense of the US, Japan and Western Europe, despite the recent volatility.

In addition, on a sectoral basis, commodities/basic materials (right pane) continue to attract capital investments again despite the recent storm. The former laggards seen in the technology sector following the bust in 2000, appears to have shown signs of a steady recovery, while financials and real estate continues to cascade. On the other hand investment flows to the energy sector looks sluggish.

For the week ended January 9, AMG Data says that the inflows towards emerging markets continues to validate the present “decoupling” trends in BRIC and ASEAN markets, this from AMG, ``Excluding ETF activity International funds report net inflows of $396 million as net inflows are reported in all Emerging and Developed regions except Latin America (-$10 Mil) and Europe (-$41 Mil)”

Meanwhile the Institute for International Finance (IIF) a financial outfit consisting of 370+ members in 65 countries projects capital flows towards emerging markets to moderate but remain vigorous (Morningstar.com), ``The IIF expects the volume of net private capital flows to emerging markets in 2008 to reach $670 billion, which represents only a modest dip in capital compared to the record $681 billion reached in 2007. The IIF estimates that the volume of net private capital flows to emerging markets in 2006 totaled $560 billion.”

To consider, as the world continues to massively print or generate money or liquidity as shown in Figure 6, these are likely to find a home.

Figure 6: courtesy of Richard Karn’s Emergingtrendsreport.com: Sampling of M3 growth

So indeed while the US has been encountering some signs of “credit contraction” via its dysfunctional financial system, other parts of the world are still massively producing liquidity and perhaps could be the reason why we are seeing signs of divergences.

Not My Grandpa’s Deflation

Besides, Peter Schiff of Euro Capital provides an important insight why such horror stories are likely to be a US centric problem than a world problem. Quoting at length Mr. Schiff from his trenchant article Not Your Father's Deflation (emphasis ours),

``However there are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing…

``Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.

``In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege…

``The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors. Since American debtors can vote in U.S. elections and foreign creditors can not, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage.”

Prediction Dilemma: The Fox versus Hedgehog

Could the depression advocates be correct? Of course they could, although we assign a smaller probability to such scenario. That is why it is highly recommended for an investor to stay defensive during these turbulent periods, which means investing only the amount of risk that one can afford (by position sizing), even if we are long term bullish over Philippine or Asian stocks.

At present, in the battle between inflation and deflation markets appear to be signaling another form of ‘flation’…stagflation. Eventually the markets will tell which among these scenarios will dominate.

You see the debate about the merits of an inflationary or deflationary outcome is basically a problem of making predictions.

Another favorite analyst of ours Josh Wolfe of Forbes Nanotech identifies two types of prognosticators, a Fox and a Hedgehog, where according to Mr. Wolfe, ``Foxes are skeptics and less confident in making predictions and build a latticework of mental models. Hedgehogs are more enthusiastic (especially about what they know) and more confident in making predictions and then pushing those predictions into all domains. As you’ll see, the quick brown renaissance Fox jumps over the staunchly opinionated Hedgehog…”

Hedgehogs tend to be radical theorists in terms of forecasting and are frequently wrong than right, which today we find relevant in the advocacy for a global depression, quoting anew Mr. Wolfe (highlight ours)…

``Some hedgehogs are often seen to predict big extreme changes. Not because they are more prescient, but they are tend to be in a minority of opinion holders for an outlandish outcome. But those outlandish outcomes are important to have out there. Hedgehogs cling to very extreme assignment of odds to something: i.e. it absolutely will never happen: 0% or it is certain to happen: 100%. As the saying goes, even a broken clock is right twice a day. The cost of being a hedgehog is a lot of false positives. They constantly predict some certain outcomes, but they are more often wrong as most do not ever occur: (remember Dow 36,000?). Hedgehogs are also more likely to be on TV as talking heads because they are more confident, more assertive and assign higher probabilities to low frequency events—which also make them more interesting to watch than someone who is more reserved.”

In our case, we’d like to emulate the fox, always studying the different scenarios or models advocated by different hedgehogs and parlay our risk according to the probability of its occurrence. The bottom line is while extreme events or “black swans” may indeed occur, the odds are stacked against such scenarios, and most especially when the scenarios projected seem to be grounded on logical fallacies.

So when we hear or read depression proponents preach about the collapse of the world, until now, it remains to be just that…a movie plot.

Investment Ideas: China’s SWF to Invest via the BAMBOO Network?

``The rise of China -- and of Asia -- will, over the next decades, bring about a substantial reordering of the international system. The center of gravity of world affairs is shifting from the Atlantic, where it was lodged for the past three centuries, to the Pacific. The most rapidly developing countries are in Asia, with a growing means to vindicate their perception of the national interest.”- Henry Kissinger, a former secretary of state, is chairman of Kissinger Associates

Last week we spoke of the growing significance of Sovereign Wealth Funds (SWFs) in cushioning global markets, where excess foreign exchange reserves of developing countries have been partially finding their way into the US financial assets and to other investments in some parts of the world.

Yes, lately there have been reports that Citigroup and Merrill Lynch have been seeking additional funding ($14 billion and $2 billion, respectively) from again-emerging markets via sovereign wealth funds (telegraph) and investors including Prince Alwaleed bin Talal (telegraph). The recycling of surplus foreign exchange reserves appears to be building momentum. In some estimates SWFs are expected to grow to about $12 trillion in 2015 (telegraph) which makes SWFs a potent player in the financial markets.

Lately, courtesy of analyst Martin Spring, we read that one of the potential avenues where SWFs could deploy their funds could be through the Bamboo Network or the Overseas Chinese, mainly through privately owned Chinese companies throughout in Asia.

According to Martin Spring (our emphasis),

``There’s a very good chance that much of the capital China is planning to invest abroad to diversify its holdings could be channelled into “Asia’s most powerful yet invisible force – the Bamboo Network,” suggests Bank of America’s chief market strategist, Joe Quinlan.

`` “The network consists of hundreds of companies across Asia owned and managed by Chinese entrepreneurs with extensive ties to their ancestral homeland,” he says.

`` “Many of these companies dominate the private sectors of Singapore, Thailand, Malaysia, Indonesia, Taiwan, Hong Kong, the Philippines and Vietnam.

`` “Large swathes of industry (transportation, banking, retail, construction and manufacturing) are under the control of the overseas Chinese.” Some businesses have grown from small family-owned enterprises into “enormous publicly-traded conglomerates.”

``Over the past quarter-century the Chinese diaspora has been the largest investor in China, sharing the same culture, language and business norms.

``Now the flow of capital is about to reverse. “China’s investment agency is likely to exhibit a regional bias towards companies run and managed by overseas Chinese executives.

``This will not only serve the objective of yielding higher investment returns, but also serve China’s broader strategic interests of creating a pan-Asian economy with the mainland at its core.

`` “The big winners are likely to be large-cap companies run by overseas Chinese entrepreneurs and, by extension, the equity markets of Southeast Asia.”

Need we say more?

Global Markets To A Rough Start, Phisix: Part of the Normal Corrective Phase

``It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.” --Gordon Gekko, fictional character from 1987 film Wall Street

2008 looks like a prelude to a very challenging year as global markets baptized the week with stinging losses as shown in figure 1.

In a single session for the week, Japan’s major benchmarks the Nikkei 225 and the TOPIX fell by a nasty 4% each. Meanwhile, the world’s inspirational leader, the major benchmarks of the US markets fumbled heftily for a worst 3 day start of any year since 1904 (Bloomberg). And this was likewise reflected in other key markets in Europe and in Emerging markets.

Figure 1: stockcharts.com: An ominous start for 2008?

Our own domestic bellwether the Phisix succumbed to its worst inaugural weekly decline since 1998. The 30-member composite yardstick fell 3.93% over the week and had been in a rolling decline marked by lower highs and lower lows seen in the main chart signified by the declining trend channel since October.

Moreover, the Phisix appears to be perched at its major support-200 day moving averages (red line) which is likely to be broken this week following the substantial losses in Wall Street last Friday. A meaningful breakdown underscores a transition towards a corrective phase.

The patent breakdown of the Japan’s Nikkei (upper pane below Phisix) could likewise be replicated in the S&P 500 (above pane). The US bellwether appears to have found some critical support at the 1,400 (in closing prices) area during the past few months. The recent lower highs should draw up a bearish declining triangle from which a breakdown could lead the S&P to the 1,300 zone. Otherwise, a bounce from this crucial support area could imply a bullish triple bottom but would need to be confirmed by a breach of the 1,525.

We see the same dynamics with Europe’s Stoxx 50, which appears to be testing its support.

All these tells us that global financial markets are presently adjusting to the unpleasant realities brought upon by the spillover of the US housing bubble meltdown, the global liquidity and credit crunch, the loss of trust on innovative financial products (securitization and derivatives), the return of risk aversion, the ramifications from a paradigm shift of monetarism (from banking to nonfinancial intermediaries or the “Shadow Banking System”-as labeled by PIMCO’s Paul McCulley) and the perceptible deceleration of economic growth previously stimulated by the “Ponzi” dynamics as seen through the massive speculative inflationary driven forces.

One important aspect overlooked by mainstream analysis is that today’s marketplace dislocation is a fundamental function of structural insolvency of the balance sheets by the US banking system (estimated at $12.7 trillion- Dr. John Hussman), rooted on borrowers who recklessly speculated on assets (in expectations of short-term gains and a perpetuation of jubilance) and who engaged in egregious consumption from whose debts have burgeoned to unwieldy magnitudes such that these have become unserviceable and have likewise been exacerbated by the collapse of assets from which such speculations were anchored to.

The continuing risks is that all these redounds to a monetary tightening as the banking system react defensively by hoarding capital via loss writeoffs and selling of assets or equities to boost reserves while simultaneously reducing money allocated for regular operations.

Needless to say, these implied tightening coupled with insolvent borrowers risks a potential contagion in consumer loans such as credit cards and auto loans (signs of rising delinquencies-Associated Press), or in other business aspects such as US commercial real estate or diminished capital expenditures.

Moreover, similar risk dynamics are seen affecting some major markets and economies in Europe which had similarly benefited from leveraged mortgage prompted property booms in UK, Spain, Ireland etc. (menafn.com), such that further afflictions of these markets may give rise to enhanced risks on state fiscal conditions (lower taxes on same level of expenditures leads to deficits) and heightens default risks on Credit Default Swaps, corporate High yield bonds and Derivatives Counterparties, aside from potential risks on residual losses from hedge funds and the nonfinancial banking system.

In effect, the financial sector which had served as a key backbone for the property boom in Anglo Saxon countries has now been suffering from the repercussions of its previous excesses.

In addition, recent economic data suggests that the US may already be in recession- “began a recession in December” as averred by PIMCO’s top honcho Bill Gross (nationalpost.com)-if not at the verge of recession, possibly evidenced by a sharp jump in unemployment to a 2 year high (Bloomberg) and a notable contraction in the manufacturing sector as measured in the ISM factory index-the most in 5 years (Bloomberg).

Now if past performance were to repeat itself, then the average losses as measured by the major equity benchmarks in the US from peak-to-trough during a recession is about 40%. This means that given today’s nearly 10% decline from the peak, major equity benchmarks could fall by another 30%. That is IF history will rhyme.

Yet, the present actions by central banks, such as the US Federal Reserve, mainly deal with the liquidity dimensions of the present problem. Some analysts opine that the recent actions of major central banks appear to be directed towards the “normalization” of LIBOR rates, aimed at stabilizing credit flows, which had earlier spiked relative to Fed rates, as discussed in December 10 to 14 edition, [see Market’s Response To The Fed’s 25 Basis Points: Sell The News] to evince of such tightened conditions. The LIBOR rate is a very significant reference rate used in the financial markets which are supposedly tied to some $150 TRILLION of derivative pricing (Jim Bianco as quoted by David Kotok of Cumberland Advisors).

While rate cuts cold help alleviate present circumstances it won’t sufficiently resolve the insolvency issues confronting both the borrower (general public) and the lender (balance sheets of the banking system) and the ensuing confidence crisis. With the current financial markets turmoil still persisting in spite of the recent activities by central banks to cushion its impact with the panoply of diversified measures, we can expect more intensified activities from monetary authorities going forward. So while financial compression in the private sector harries markets of western nations (deflation), global central banks are likely to concertedly exhaust their bandwith of arsenals to stave off a global recession (inflation). It is the appearance of “shocks” or black swans that risks destabilizing global markets.

Bottom line: What we expected to happen in 2007 appears more likely to occur in 2008. As seen in last week’s selling pressure, global financial markets are likely to face trying times as downside volatility seems to have reasserted itself. If the US is indeed undergoing a recession or falls into one over the short run, then the Phisix in tandem with other markets would initially feel its immediate impact. One must remember that the peak of US mortgage resets is still in process (from October 2007 through April 2008).

In short, while we believe the Phisix and Asia is in a secular bullmarket, countercycles are a normal and healthy component of any long term trend.

Survey On Local Sentiment, Stock Market Cycles Based on Psychology

``The fact of storytelling hints at a fundamental human unease, hints at human imperfection. Where there is perfection there is no story to tell.”- Ben Okri, Nigerian Poet and Novelist

The Christmas holiday with its incidental social gatherings is one great opportunity to evaluate investor sentiment.

While of course, these occasions do not represent the entire constellation of investors in the Philippine stockmarket, we try to interpret the information we obtained from the ground level with that manifested by market internals.

Noticeably there seems to be a widespread enthusiasm for stock market. This is in stark contrast to 2002, where talk of the stock market was an anathema to any crowd. Today even some housewives appear to dabble or talk inspiringly of the “wonders” of the industry.

In fact, the mere mention of stock market triggered lengthy discussions of its myriad scope; from developments in companies, micro economics and or politics as influences, and rumored activities by insiders aside from recent “successful” exploits.

The levels of participants were of varying degrees- from fledging investors to finance professionals-where most appear to fall into the average category; whose decision making are prompted for by broker-reports or through mainstream media or via social networks.

Here are some points we gathered from them:

1. Feasible business opportunities seem limited.

2. Rising Peso reduces the incentive to invest in the US dollar.

3. Interest rates are so low that the market appears to be the only option to generate satisfactory returns.

4. Stock market returns have been strong relative to other businesses or money market instruments and is strongly expected to remain robust.

5. Stock market returns are driven by developments in individual companies or the economy or politics.

However, a friend pointed out to me that in online forums, participants have not been as sanguine. Some were said to have shown signs of anxiety or fear emanating from the recent bouts of volatility.

Figure 2: Stock Market’s Psychological Cycles

While it maybe true that some fears may have been exhibited by some participants due to the recent volatility (rear view mirror syndrome), the fact that they remained active online means that they are hopeful and in search for an opiate.

To our experience, as signified by Figure 2, the average investors typically abdicate on the market when they capitulate or has given up hope (but with long positions) and thus abandoned the market. Such is the reason why no one seems interested about the markets in 2002, where the opportunities for maximizing returns were at its greatest.

Yet in every stock market cycle these psychological shifts transpire.

Figure 3: PSE: Market Internals Number of Trades and Number of Issues Traded

Figure 3 from the Philippine Stock Exchange shows on the left pane the daily number of trades and at the right pane the daily number of issues traded.

Since the Phisix cycle reversed in 2002, both activities accounted for an ascending trend.

For the daily number trades at the left pane, trading activities jumped to the max in April of 2007 and has been on a decline since the credit crisis erupted. Today, the daily number of trades has fallen to the mid 2006 levels.

Essentially, the number of trades reflects on the trading sentiment for traders or punters to positively churn their positions. The fall in the number of trades depict of short term traders/punters caught into buying ‘market tops’ and have morphed into long-only investors (again see figure 2) or retreated to the sidelines (less likely scenario). This appears to be a confirmation of the sentiment visible on the online forums.

The right pane shows of the number of issues traded. This indicator signifies general investor sentiment. When market participants generally turn optimistic the tendency is to position over to the broader market. In the past, we have made the 120 line as a yardstick demarcating optimism from pessimism.

Today, the number of issues traded remains at the peak albeit with signs of tapering (red arrow). This suggests that the investors generally remain optimistic buying into the broader market but has been trading somewhat less. Such developments again appear to validate our views from the ground on investors still optimistic but on a denial phase.

While we do expect some material reduction of activities in the face of externally instigated selling pressures over the interim, we do not expect these indicators to return to the 2003 or 2004 levels considering our view of the present cycle as a normal countertrend amidst a secular trend development.

In a way, some of the issues raised by the participants whom I listened to had valid footings such as the firming Peso and the low interest rates. Thereby, the recent activities exhibited by local investors in shoring up the Phisix, which resulted to a slim majority in 2007 at 50.22% of total Peso trade) could likely be a trend well into 2008 (in the assumption that foreign investors remain net sellers- which is very unlikely; foreign investors are likely to resume their net buying as US markets probably turn lower).

China’s Rising Remimbi To Spur Continued Rise of the Peso

``When everybody knows that something is so, it means that nobody knows nothin’.” Andrew S. Grove, co-founder of Intel

Meanwhile the Philippine Peso which appreciated by about 18.77% in 2007 for its biggest annual gain and the best performer in Asia for 2007 (economictimes.indiatimes.com), should be expected to remain strong in line with other Asian currencies, albeit at a much subdued pace compared to 2007.

China’s rising inflation and geopolitical pressures latched on growing “protectionist sentiment” in the US may prompt Chinese authorities to accelerate the pace of appreciation or conduct a huge one off revaluation vis-à-vis the US dollar.

Since the brunt of the global currency adjustments have been through the western managed free floats, Asian currencies, which had in the past maintained a mercantilist regime by subsidizing exports through currency manipulation and supporting US assets via investing its surpluses to US treasuries or other US assets known as the informal Bretton Woods 2, remain highly undervalued. Besides the continuation of a massive buildup of foreign reserves and strong capital flows are expected to remain vibrant. This runs under the assumption that the US economy and its financial markets won’t do a spectacular swan dive or the world won’t succumb to deflationary pressures.

As for the US dollar index, sentiment has been excessively against the US dollar such that Brazilian super model Gisele Bundchen, rapper Jay-Z and India’s tourist spots have eschewed the US dollar for other currencies for their revenues.

Meanwhile, a recession in the US which percolates to a slowdown elsewhere in the world is likely to prompt for monetary policies targeted on growth revival than inflation control, and thus, rate cut measures in offing for the Euro zone or in Canada or UK which means a stronger US dollar index for 2008 (most especially if the US capitulates to deflationary forces).

On the other hand, the Japanese Yen is likely to resume its uptrend as global markets remain under pressure as the carry trade unwinds (so with the Swiss Franc).

Nonetheless, as a side comment, talking of belated political reactions, the Philippine government recently responded to declining income from OFWs as a consequence of the rising Peso via the introduction of hedging facilities (pia.gov.ph). This is a clear example of government’s reactive nature. By liberalizing the markets, private initiatives would have addressed the issue earlier and have competed to provide the best programs for the benefit of OFWs, exporters and those affected by the rising Peso.

Negative Real Yields, Sovereign Wealth Funds and Back to the Future

``Do what you will, this world's a fiction and is made up of contradiction.”-William Blake (1757-1827), English Poet, Printer and Printmaker

True enough the uncertainties in the US financial system and its economy is duly a cause of concern which again is likely to impact the interim direction of our markets. However, we do not share the sudden resurgence of the “recoupling” argument.

In the world of financial globalization, integration is the byword, or in essence, markets and economies are expected to “couple” relative to cross border capital flows, trading and other economic activities and in the financial markets. But the diversity in the structures of the economies or the markets or of policies or a combination thereof is unlikely to produce a perfect integration. The “Dry Bone” inference of the foot bone is connected to the anklebone is connected to the leg bone is connected to the hipbone etc… signifies oversimplified thinking.

For instance we have long argued that monetary policies have had in the recent past served as an important influence to global asset classes. While it may be also accurate in the past that the “when the US sneezes the world catches cold”, past performance may not be an accurate indicator of the future.

This important quote from Dr. Marc Faber, ``Moreover, it would be wrong simply to assume that recession and slumping corporate profit will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed fund rate, a weak dollar, and “bubbly” emerging markets could make US equities a relatively attractive proposition compared to other financial assets.”

One can just take a glimpse of the bourses of the Gulf Cooperation Council which appears to have decoupled from most global equities in view of their exploding performances. Why? Because of the monetary regime -a US dollar peg, which has effectively tied their domestic policies with that of the US.

The declining US dollar have in essence imported inflation into these countries teeming with surplus foreign reserves which seems to be giving investors a one way bet in anticipation of a break of the currency peg. Where the underlying inflation rates are greater than nominal policy rates redound to negative real yields as described by Dr. Faber.

In short, central banks can control the money they print but they can’t control where it goes. This leads us to the recent breakaway run in gold prices amidst the deflationary backdrop in Anglo Saxon economies shown in Figure 4.

Figure 4: Prieur Du Plessis/Plexus Asset Management: Rampaging Gold Prices in Various Currencies

Gold has not been rising based on the US dollar alone, but against almost all major currencies as shown in the above chart courtesy of Prieur Du Plessis.

And you think oil’s $100 milestone high is all about demand and supply as academic “know them all” experts tell you. Check out Figure 5.

Figure 5: stockcharts.com: Falling US dollar Index and Rising Oil prices!

For over two years the peaks and troughs of the US dollar and the Oil prices appears to have been “perfectly” synchronized (green arrows); each time US dollar peaks oil bottoms and vice versa. This simply suggests that a decline in the value of US dollars, the currency from which oil is predominantly traded, has likewise prompted a rise in oil prices. In short, oil prices, aside from demand and supply, simply reflect on the relative declining value of the US dollar.

If gold, oil and the GCCs are manifesting a departure from the “recoupling” theme, why shouldn’t emerging markets?

Our views have almost been isolated given many apostasies among former decoupling advocates, except for one, incidentally a favorite…BCA Research,

Figure 6: BCA Research: Emerging Market Decoupling to Persist into 2008

According to BCA Research (our emphasis), ``The economic decoupling between emerging economies and the U.S. is attributable to underlying fundamentals and is therefore sustainable. Unlike in the 1990s when emerging economies relied on foreign capital to finance their expansion, many of these countries are now net creditors in global financial markets and are not vulnerable to a withdrawal of financing by G7 banks. Domestic interest rates are still very stimulative thanks to their strong currencies and vast savings, which will continue to underpin domestic demand growth. While exports to the U.S. have been slowing, trade among developing economies is booming. As a result, overall emerging market growth will not slow considerably, even if the U.S. economic slump continues. Bottom line: Our Emerging Markets Strategy service recommends that investors continue to overweight emerging equity markets within a global portfolio.”

True, as net creditors emerging markets via Sovereign Wealth Funds armed with an estimated $2.5 trillion of investible funds and assets, have been on a buying spree for distressed US assets and elsewhere around the globe…

From Bloomberg’s Zachary R. Mider (highlight mine), ``Foreign investors exploited the declining U.S. dollar during the past three months to snap up American companies at the fastest pace in at least a decade. Buyers from Dubai to the Netherlands accounted for 46% of the $230.5 billion of U.S. mergers and acquisitions announced in the fourth quarter, the biggest share since 1998 when Bloomberg started compiling the data. The total excludes $17.9 billion of so-called passive investments by state-run funds in Asia and the Middle East in U.S. banks, including New York-based Citigroup Inc.”

From Telegraph’s Ambrose Pritchard (highlight mine), ``Abu Dhabi's giant fund Adia ($875bn) rescued Citibank with a $7.5bn equity infusion, taking advantage of the US mortgage crisis to scoop up 4.9pc of the world's top bank for a pittance…

``The modus operandi of the funds is to dip their toe in the water, then build up a strategic stake gradually if all goes well. Temasek has taken a 2pc share in Barclays, while China's Development Bank holds 3.1pc - a stake that may be in doubt after Barclays' failed bid for ABN Amro.

``Dubai's various state-controlled bodies hold 2.2pc of Deutsche Bank, 3pc of HSBC, 3.5pc of Euronext, 2pc of Perella Weinberg Partners, 28pc of the London Stock Exchange, 20pc of Nasdaq and 68pc of Thomas Cook India.

``Abu Dhabi has pushed its stake in Mid-East banks to 30pc or 40pc, or even 97pc in the case of BLC Bank in Lebanon. Whether Western countries will tolerate strategic creep of this kind is another matter.

From S&P (highlight mine)…

``Temasek Holdings, based in Singapore, has equity in a range of banks, including Barclays, Standard Chartered, China Construction Bank, DBS Bank, ICICI Bank, and Sberbank.”

Thus would it be a wonder why perceptions on emerging markets have encountered a remarkable makeover?

This from Dow Jones’ Charles Roth and Claudia Assis (highlight mine)… ``Traditionally, investors would scramble from emerging markets at the first signs of trouble within the asset class or in response to global market volatility and tightening credit. But after four straight years of big annual gains, 2007 became not only the fifth year of clear outperformance but the first in which emerging markets became something of a safe haven from the implosion in the U.S. subprime mortgage market and the subsequent fallout…”

Deflation advocates claim that Sovereign wealth funds will simply deplete their surpluses by throwing money after bad assets. The assumption is that these state owned funds (state capitalism-Brad Setser) would function like unthinking zombie investors buying up US assets which will continue to collapse. Maybe, but seems quite unlikely if not outrageous.

From the Financial Times (highlight mine)… `` A secretive Hong Kong-based subsidiary of China’s State Administration of Foreign Exchange, manager of the world’s largest foreign exchange reserves, has bought stakes in three of Australia’s largest banks, raising fresh questions about transparency of China’s sovereign wealth investments in international markets.

``Australia and New Zealand Bank and Commonwealth Bank of Australia said Hong Kong-registered SAFE Investment Company had bought stakes of less than one per cent in each of the banks. An entity with the same name has taken a stake of about one-third of a per cent in National Australia Bank , people inside NAB reckon.”

It is no doubt why such level headed fund managers believe that emerging markets are still likely to outperform US markets despite the present juncture.

Lastly over the long term, the present divergence is likely to be a representation of a continuing transitional shift in market leadership, see Figure 7 courtesy of Chris Gilpin of Casey Research…

Figure 7 Resource Investor/Casey Research: Shifting Market Leadership

From the S & P 500, the market leaders had been energy and basic materials in late 70s to technology in the late 90s to financials into the new millennium… Are we seeing a shift back to energy and basic materials? Back to the Future?