Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited.”- George Soros

Activities in the financial markets can never be explained in a straightforward narrative manner.

You’d probably wonder why despite gloomy economic news in the US and in other major developed economies aside from declining corporate profits, global stock markets continue to remain elevated or are surprisingly even advancing.

Moreover, as commodities recently tanked some observers commented that the reason stocks are recovering could be due to falling inflation pressures which could likely improve corporate margins. Such argument appears unfounded.

If it is true that commodities prices have been boosted by soaring demand, then the present pace of decline should imply of contracting demand, which could be reflective of a meaningful downshift in global economic growth, see figure 5.

Figure 5: US Global Investors: Moderating Asian Exports

Asian exports are, as shown by US Global Investors, all rolling over led by a severe decline in US imports. Now the decline has been similarly seen with European imports but in a time lag. Imports of commodity producers have likewise “peaked”.

Thus, by sheer induction, equity asset prices should continue to face pressures from downside revaluation, unless the markets foresee a recovery over the near term (which is very unlikely).

In addition, if it is also true that the falling US dollar have prompted for a commodities “bubble” as argued by some then the recent US dollar rebound suggests of liquidity contraction or a monetary tightening which should also signify negatively for equities too.

Yet, stock markets continue to perform strongly even when seasonality factors such as “Sell in May and Go Away” say it shouldn’t.

Drooling Over US Financials

Meanwhile others have been drooling over at the gains accrued by the US financials following the recent bear market “reversal” marked by the buyout by JP Morgan of investment bank Bear Sterns under the facilitation of the US Federal Reserves. The impression etched by the rallying US financials is that it has bottomed or is on a path towards recovery.

We doubt such premise. To quote Mohamed El-Erian of PIMCO,

``Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.”

This means that even if the Fed have “successfully” patched some of the liquidity dislocations in the financial markets (as evidenced by some improvements or narrowing of credit spreads) by absorbing tainted assets as eligible collateral, recessionary pressures from the real economy could add to its portfolio (consumer) loan losses which are likely to require additional capital raising exercises given the delicately compressed capital ratios, as much it is likely to its impact business operations in an environment of slowing demand, tighter lending standards and reduced investments.

Nevertheless, the disruptions (unidentified losses) in asset securitization remain an unresolved problem aside from the onus of new government regulations.

Global Central Banks Inflating Away….

So, again why are the stock markets surging?

Quoting Fritz Machlup in The Stock Market, Credit and Capital Formation ``... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply.”

In contrast to mainstream analysis, our view on the stock market has always covered “inflationary” policies conducted by monetary authorities.

It is a reason why we believe stock markets don’t always relate to the oversimplified tale of micro/macro economics or corporate earnings and may diverge from “realities”. Because central banks can always excessively inflate the system, from which to serially “blow bubbles” in terms of assets or goods as the purchasing power of a currency erodes.

We always love to cite Zimbabwe as an example. The country has been suffering from successive years of chronic hyperinflationary depression whose inflation rate is 165,000%, has 80% unemployment rate and whose currency is traded at Zimbabwe $150 million per US dollar when officially pegged currency is at Zimbabwe $ 30,000 to a US dollar or 5,000x its official rates! You can just imagine the Philippine Peso pegged at 42 to a US dollar but whose black market rate is at P 210,000 to a US dollar.

Yet in spite of the depressed earnings (no earnings to talk about) and a recessionary economy, its stock market has soared by 360% in just three weeks! See the irreverence to mainstream analysis?

We seem to have the same dynamics today in global markets. What we could be witnessing is the impact of concerted REFLATIONARY policies by global central banks. And this has could have spurred the “rotation away” from commodities and into the general equity markets spearheaded by the financials (But this “rotation” isn’t likely to be a lasting trend).

This from Morgan Stanley’s Joachim Fels, ``global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years.”

So essentially, the Fed has been injecting steroids into the financial markets, as much as other major global central have provided liquidity support to a distressed financial system, while emerging markets have long undertaken expansionary policies that has nurtured explosive demand growth in food and energy. In addition the recent spikes of food prices have further aggravated such these inflationary measures of instituting safety nets to buy off political stability.

Figure 6 US Global Investors: Asian Real Rates are Negative!

So circumstantial evidence suggest that the recent bounce in global equity markets could have been in response to the expansionary monetary policies whose real interest rates has somewhat turned negative, as shown in figure 6 courtesy of US Global Investors which accounts for the average real rates in Asia. The region holds about 70% of foreign exchange reserves. Negative real rates are likely to support more leverage driven speculative activities.

Dissent Over Subsidies, Risks of Heightened Inflation and Moral Hazards

And the efforts to subsidize the financial system has not ended in the US as the US Federal Reserves continues to expand the scope of its outreach “nationalization” programs to cover unconventional areas as student loans, credit card debts and car loans as collateral for financial institutions.

Some experts/authorities have expressed dismay over the seeming relentless use of taxpayers money to support the financial sector…this quote from Bloomberg, ``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Two more quotes from the same article,

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The point is that policy measures undertaken by the Bernanke leadership have clearly caused some vocal dissent over the risks of increased inflationary pressures.

Snippets

The snippet of my observations:

-Inflationary activities (marked by negative real rates) by global central banks could have been responsible for bloating global equity markets.

-The recent outperformance of the financials which took away the centerstage from commodities isn’t likely to be an incipient long term trend, as continued inflationary “nationalization” programs are unlikely drivers for such reversal. Moreover, recessionary pressures in the US economy are likely to limit any progress for US financials.

-The commodity cycle works best in a negative real rate environment. This could mean that the recent decline of commodities doesn’t account for a hissing bubble but possibly of a normal corrective phase following its near parabolic ascent.

-The expectation of a reversal of the US dollar long term downtrend coming off a Fed pause is likely to be too optimistic. Since the Fed keeps expanding the reach of its bridge financing bridge facilities, this seems enough evidence that its credit system has not yet normalized and could signify as a considerable obstacle to expectations of an earlier recovery by the US economy relative to the world. In short, the US dollar’s recent rally could be an oversold technical bounce.

-While activities in the US treasuries could imply the end of the Fed rate cycle, this would likely depend on the activities in the US stock market which evidently has been proven as a mainstay barometer of Mr. Bernanke.

-Back to the Philippine Stock Exchange. Against a backdrop of recovering world markets, the Phisix seems to be the only laggard for unclear reasons. Yet, as we mentioned before, excessive negative sentiment, negative yield environment, extremely oversold levels and favorable external developments have recently aligned to suggest of a looming noteworthy tradeable bounce if not a potential bottoming process.

Figure 7: ino.com: Rice Prices Off the Record Highs

If the excuse for this slump has been predicated on the rice crisis, then as figure 7 courtesy of ino.com suggests, such “rationalization” may not hold soon.

Noteworthy Insights on the Rice Crisis

Some important insights on the Rice Crisis…

All highlights mine

From Tyler Cowen published at the New York Times…

“Restrictions on the rice trade run the risk of making shortages and high prices permanent. Export restrictions treat rice trade and production as a zero- or negative-sum game where one country’s gain comes at the expense of another. That’s hardly the best way to move forward in a rapidly growing world economy.

“This lack of support for trade reflects a broader and disturbing trend. An increasing percentage of the world’s production, including that for agriculture, comes from poor countries. Over all, that’s good for rich countries, which can focus on creating other goods and services, and for the poor countries, which are producing more wealth. But it can slow the speed of adjustment to changing global conditions.

“For example, if demand for rice rises, Vietnamese farmers — who remain shackled by many longstanding regulations of communism — aren’t always able to respond quickly. They don’t even have complete freedom to ship and trade rice within their own country.

“Poorer countries also tend to be the most protectionist. To make matters worse, about half of the global rice trade is run by politicized state trading boards.

“The reality is that many of today’s commodity shortages, including that for oil, occur because ever more production and trade take place in relatively inefficient and inflexible countries. We’re accustomed to the response times of Silicon Valley, but when it comes to commodities production, many of the relevant institutions abroad have only one foot in the modern age. In other words, the world’s commodities table is very far from flat.

“Many poor countries, including some in Africa, could be growing much more rice than they do now. The major culprits include corruption in the rice supply chain, poorly conceived irrigation systems, terrible or even nonexistent roads, insecure property rights, ill-considered land reforms, and price controls on rice.

“The ability of a country to grow rice depends not just on its weather, but also on its institutions. Burma, now Myanmar, was once the world’s leading rice exporter, but it is now an economic basket case and many of its people go hungry.

“Of course, wealthy countries are partly at fault, too. Japan, South Korea and Taiwan all protect their native rice farmers; you’ll even see rice being grown in Spain and Italy, aided by European Union subsidies and protectionism. The United States spends billions subsidizing domestic rice farmers.

From Steve Hanke published at Cato.org...

“The economics of commodity markets provides the key to unlocking this mystery. The net cost of carrying inventories is equal to the interest rate, plus the cost of physical storage, minus the "convenience yield".

“The convenience yield is driven by the precautionary demand for the storage. When the convenience yield is zero, a market is in "full carry", future prices exceed spot prices and inventories are abundant.

“Alternatively, when the precautionary demand for a commodity is high, spot prices are strong and exceed future prices, and inventories are unusually low.

“As the term structure of rice prices makes clear (see chart), the precautionary demand in Thailand is not elevated and inventories are ample. Indeed, for the term structure of prices to be signaling unusually low inventories, the term structure would be negative in slope, not positive.

Chart courtesy of Cato.org

“In most countries, rice production and trade are subject to a plethora of laws and regulations. Subsidies to rice producers and consumers are widespread. Tariffs on imports and exports are common, as are import and export quotas.

“Many of these policies derive from a food security rationale and the desire to keep a large proportion of rice production at home. In consequence, rice markets are segmented, with wide differences in rice prices (adjusted for rice quality and transport costs) among countries.

“Not surprisingly, a relatively small proportion – only 6%-7% – of world production is exported.

From IMF’s Dominique Strauss-Kahn

“Although aid is the first step, we must be bolder in tackling the long-term challenges of food supply.

“Many farmers are not increasing output because they are not equipped to gear up production or because market distortions mean they do not benefit from higher food prices. So, just waiting for the market to self-correct is not a satisfactory option.

“We must not lose sight of longer-term solutions. This calls for a more global approach to policies. Agricultural policies must change. Higher food prices over the past few years in part reflect well-intentioned, yet misguided policies in advanced economies, which attempt to stimulate biofuels made from foodstuffs through subsidies and protectionist measures.

“High food prices also reflect imprudent agricultural pricing policies in some developing countries, and these too need to be improved.

“No one should forget that all countries rely on open trade to feed their populations. But we are already seeing actions at the national level, such as curbs on food exports, that have a damaging global impact. Completing the Doha round would play a critically helpful role in this regard, as it would reduce trade barriers and distortions and encourage agricultural trade.

“The International Monetary Fund and the World Bank are also engaged in discussions to improve both industrial and developing country policies. Multilateral agencies are stepping up lending to the agricultural sector in poorer and middle-income countries to encourage and support good policies. But there is more to do, and the World Bank's New Deal on Global Food Policy is a big step forward.

“We also need a new approach to risk mitigation and insurance at the level of both individual farmers and countries. Important steps are being made in this direction by aid donors with regard to catastrophe insurance and developing robust futures markets. This can greatly help assure farmers that, if they make investments, they will reap the rewards.

“We should consider adopting a similar philosophy to dealing with shocks - including, but not limited to, energy and food prices - at the macroeconomic level. Countries need to feel more assured that insurance-type financing will be available in times of need. The IMF will play its part in this regard.

From Martin Wolf of the Financial Times...

“Are prices going to remain high? Two opposing forces are at work. The first is the market, which will tend to bring prices back down as supplies expand and demand shrinks. But the latter is also what we want to avoid, at least in the case of the poor, since reducing their consumption is not so much a solution as a failure. The second force is the current intense pressure on the world's food system. This is true of both demand and costs of supply. Prices are likely to remain relatively elevated, by historical standards, unless (or until) energy prices tumble.

“This, then, brings us to the big question: what is to be done? The answers fall into three broad categories: humanitarian; trade and other policy interventions; and longer-term productivity and production.

“The important point on the first is that higher food prices have powerful distributional effects: they hurt the poorest the most. This is true both among countries and within them. The Food and Agricultural Organisation in Rome recently listed 37 countries in substantial need of food assistance. Moreover, according to the World Bank, soaring food prices threaten to make at least 100m more people hungry.

“Increases in aid to the vulnerable, either as food or as cash, are vital. Equally important, however, is ensuring that the additional supplies reach those in greatest difficulty. The options depend on the sophistication of a country's bureaucratic machinery. But they include work paid directly with food (which is a good way of screening out the better-off), a rationed supply of cheap food for the poor or cash vouchers. Those most in need will be the landless, both rural and urban, and marginal subsistence farmers.

“Now turn to the policy interventions. Protection, subsidies and other such follies distort agriculture more than any other sector. Alas, the opportunity to eliminate protection against imports offered by exceptionally high world prices is not being taken. A host of countries are imposing export taxes instead, thereby fragmenting the world market still more, reducing incentives for increased output and penalising poor net-importing countries. Meanwhile, rich countries are encouraging, or even forcing, their farmers to grow fuel instead of food.

“The present crisis is a golden opportunity to eliminate this plethora of damaging interventions. The political focus of the Doha round on lowering high levels of protection is largely irrelevant. The focus should, instead, be on shifting the farm sector towards the market, while cushioning the impact of high prices on the poor.

“Finally, far greater resources need to be devoted to expanding long-run supply. Increased spending on research will be essential, especially into farming in dry-land conditions. The move towards genetically modified food in developing countries is as inevitable as that of the high-income countries towards nuclear power. At least as important will be more efficient use of water, via pricing and additional investment. People will oppose some of these policies. But mass starvation is not a tolerable option.

From Caroline Baum of Bloomberg,

“Many Asian countries, including India and Vietnam, are banning rice exports to ensure adequate domestic supplies. Last week, Indonesia stepped up border patrols to guard against rice smuggling.

“By barring producers from selling overseas, demand for rice in any given country is lower than if the Asian food staple were freely traded internationally. The demand curve shifts back, the price and quantity demanded are reduced….

“It may be a noble idea for poor countries to transfer income from producers to consumers, but it's one that comes with a long history of unintended consequences.

“Governments continue to interfere with the law of supply and demand; that's to be expected. What's surprising is that so many practitioners of the dismal science can't seem to get it right either.

Does Declining Remittances By Latinos Bode Ill For The Philippines?

This is where it gets interesting.

chart courtesy from the New York Times

This from New York Times’ Julia Preston…

``In a sign that the economic downturn is hitting hard among Latino immigrants, more than three million of them stopped sending money to families in their home countries during the last two years, the Inter-American Development Bank said on Wednesday.

``With fewer people sending money home, money transfers to some Latin American countries have started to decline, reversing five years of often spectacular growth. In the first quarter of this year, transfers to Mexico dropped 2.9 percent from the first quarter of 2007, Mexico’s central bank reported on Wednesday, the first significant decline since Mexico began tracking the transfers in 1995.

``For Latin America as a whole, the amount of the money transfers, which are known as remittances, remained virtually flat over the last two years, the development bank reported. It estimated total remittances to the region at $45.9 billion in 2008, an increase of $500 million over 2006.

``That contrasts with the period from 2001 to 2006, when the amount of remittances to the region tripled, to $45 billion from $15 billion, according to figures from the development bank, a multilateral organization based in Washington that finances development projects in Latin America. Total remittances did not drop more sharply in the last two years because those immigrants who continued to send money sent larger amounts more frequently, the bank’s survey found…

***

The Philippine Peso has been on a decline following the revelation of the Rice Crisis.

Now that we see signs of declining remittance trends in Latin America, this should pose as a double whammy for the Peso IF we believe the “experts” are correct that remittances have principally driven the Peso’s appreciation.

Let us see.

Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom

``The collapse of the southwest real estate bubble in the United States didn't prevent investors from over-investing in Asia. The Asian crisis didn't prevent the Nasdaq bubble from developing. [I was] surprised by how rapidly the crisis mentality vanished. People can forget the lessons of a painful experience very quickly, and that can lead to poor decisions." Robert Rubin (Sep 2004)

Oops. Just as we thought we found the first clues of a bottom, the Phisix got whacked by almost 4.7% over the week on ferocious foreign selling.

This could probably be due to the downgrades slapped by some foreign institutions to emerging markets economies rocked by the present rice crisis such as the widely followed BCA Research whom recently wrote (highlight mine)…

``higher inflation and upward pressure on interest rates, rising social tensions could force policymakers to forgo proven market mechanisms, creating distortions that have long-lasting and harmful economic implications. In turn, this can lead to higher risk premiums on asset markets. The negative shock and risk of pass-through from skyrocketing food prices will be greater in the economies with a rigid supply side and low competition. Moreover, countries where the currency has been sliding will feel the effect of rising global food prices much more acutely. Bottom line: We are positive on emerging equity markets as a whole, but are concerned about the outlook for South Africa, Argentina, Indonesia, and the Philippines because of the lack of supply side reforms over the past several years and escalating threats from food inflation.”

Coincidentally, countries negatively rerated by the BCA Research likewise suffered from a severe thrashing this week as shown in Figure 1.

Figure 1: stockcharts.com: Possible Impact from Downgrades

And the losses were quite severe: for the week, Argentina’s Merval plunged 3.89% (mid pane), Indonesia’s JKSE plummeted 4.63% (pane below center window-Dow Jones Indonesia Stock), and least affected, South Africa FTSE/JSE Top 40 dropped 1.59% (bottom pane-South Africa iShares).

This is not to pin the responsibility on a single research entity for having to recommend an “underweight”, (although they indeed command a good following among international financial institutions), the point is, the continued hysteria over the rice crisis has been generating a bad image at a time when the sentiment for risk aversion is high enough to severely affect domestic asset prices as we see today.

Yet, with government continually throwing in more subsidies at the expense of the country’s fiscal conditions (more short term placebos for long term damage-our children pays for increased tax burdens), we can’t entirely fault them for such dire outlook; this seems more of a self-inflicted predicament. Yes, we simply love to shoot ourselves in the foot.

Rice Crisis: Distinguishing Noise From Facts, Transmission of Price Signals As A Cause

As we said last week, while yes, there is indeed a global food crisis; the “rice crisis” in the Philippines seems more noise than reality.

First we don’t see snaking queues for commercial rice. Those lines in TV and elsewhere in media are with subsidized NFA rice.

Second, evidence exhibits that it is largely a policy induced crisis. Subsidies have been providing incentives for arbitrage opportunities through price spreads from which some people have responded to, thus aggravating the demand supply imbalances.

Next, you have a central bank promoting more inflationary policies by keeping interest rates at present levels while consumer prices have been surging. This deepens the incentive to “hoard” tangible goods as the purchasing power or the “store of value” of the Peso diminishes.

Moreover, we have argued that price signals have not filtered to farmers enough for them to increase income or investments, as their output have long been constricted by traders and merchants and by price controls from the government purchases. An article from the Inquirer.net supports this premise,

From Philippine Senator Edgardo Angara, ``By the time the NFA comes in, the traders have already scooped up the entire harvest. They cannot even buy 10 percent. If you buy less than 10 percent, you're not going to influence the price movement.”

More again from the Inquirer (emphasis mine)…

``Maintaining stable prices all year round within reach of the poor and yet at the same time providing farmers with reasonable profit had been an NFA conundrum. NFA has suffered significant losses through the years as prices had been volatile and incomes of farmers have been low.

How does one maintain stable prices and reasonable profit for farmers when the market is controlled by select interest groups and by the government? The problem is essentially one of effective transmission of price signals to the farmers arising from misdirected government intervention.

When rice prices are capped and manipulated by certain interests groups aside from the lack of alternative markets (commodity spot and futures) which restricts output, financing access, hedging options and insurance coverage the result is the above “conundrum”; imbalances whose pressures have been building eventually reaches a culmination point-today’s crisis.

You don’t solve the problem of price signals with more price distorting interventions. Not even with absurd populist solutions as the so-called “genuine land reform” with poor international track record or more “distribution” centers which do nothing but increase taxpayer’s burden and resource allocation inefficiencies.

Again to quote Senator Angara (emphasis mine), ``If we let go of the NFA and give it full rein subsidizing and importing rice, then we will have a bottomless pit that will be hard to fill because it will consume so much of our taxpayers' money."

If a full subsidy to the NFA, whose institution has been reckoned as ineffectual and a source of corruption, consumes much of our taxpayers’ money, in the words of the good senator (at least we are delighted to see a politician display a good deal of common sense!), what do you think goes with land reform or more government distribution centers? You only throw the public’s money to address the symptoms and not the cause. Moreover, an unthought-of reactionary response tend to have unexpected consequences at the expense of the general public via direct or indirect taxation (higher prices) or other future crisis! In addition, you don’t get increased productivity by edict (Stalin and Mao tried it and failed miserably); it is done via the transmission effects of prices through profits.

Third, the fact that 1 million hectares of fallow agricultural properties had been reportedly leased to China is circumstantial proof that there are large scales of “unproductive” and “uncultivated” lands which simply needs to activate in order to contribute to the supply factors.

Market directed or government instituted, these idle lands will come into play as the global commodity cycle will induce more investments in response to supply demand asymmetries as reflected by market prices.

Notwithstanding, technological advances will certainly usher in the next wave of Green Revolution, an era marked by surging agricultural yields (1940-1960s) powered by product innovation.

We are not only blessed with vast amounts of agricultural lands, we are also fortunate enough to have the world’s major rice institute the International Rice Research Institute (Irri) headquartered in the Philippines. Reports say that the IRRI are in the final stages of introducing a new biotech hybrid variety (Aerobic and Submarine) which have the potentials to increase harvest yields by reducing sensitivity to drought, flooding or salinity.

Of course, there is always opposition to anything, this time the issue centers on compelling our farmers through taxpayer funds to adapt to this hybrid. If the new product has the potentials as advertised, it won’t need government’s money to get accepted and become a standard.

The point is that higher prices are forcing new investments into the industry as well as in the technology frontier which eventually translates to more supplies.

That’s why we’ve been bullish with agriculture all along. Have we not been right with this cycle?

Rice Crisis and Political Survival

Of course another dimension or ingredient to this problem is one of politics; the need by the incumbent to be seen by the public as doing something or what I call the Superman effect. People are wired to see images of heroes in action, thus the natural predisposition towards publicity stunts.

With a politically embattled administration coming off from a slew of scandals, such crisis provides the opportunities for diversionary PR stratagem, which perhaps is part of the theatrical plot, at the expense of our financial markets. What more attraction than to throw the public’s money to the “poor”! As a neighbor quipped, for “Pogi” points.

Everybody bleeds for the poor, the problem is more solutions via inflationary policies and price distorting laws or policies addressed to the “poor” increases the numbers and plight of the “poor”. People can’t seem to differentiate the trade off between today and tomorrow.

And this also why much of the world is turning into “socialism” via inflationary policies which will certainly keep the tabs of rising consumer prices until eventually either prices will be so burdensome enough to choke off demand where any government stimulus won’t work (“pushing on a string”) or provoke wars or prop more dictatorial regimes (furthers inflation) or that people would come to the realization of governments’ pretensions via the collapse of the present money standard or until a new “Paul Volker” appears.

Phisix: Still In Search For A Bottom

Nevertheless, with respect to the Phisix as we noted last week, while sentiment has produced some signs of a potential bottom, we further commented that this has to be backed or confirmed with positive technical action coupled with DURABILITY from external factors. This week’s action proved otherwise.

The intense selling produced a divergence with most international stock market benchmarks effectively decoupling from us as we turned lower.

Meanwhile, technical actions dramatically deteriorated as the Phisix fell to its major support level (again see Figure 1) where it is presently perched with the likelihood of a potential breakdown test given the intensity of the latest shakeout.

There are two likely scenarios here, one is that a successful breakdown means that a Phisix floor has yet to be established which means there could be more downside market actions.

The other is that the Phisix bounces from the present levels or from its 2,773 lows which could carve out a bullish double bottom pattern. Yet even if a double bottom does emerge it could take probably take sometime before the Phisix recovers meaningfully and exit from its declining phase reinforced by improving market action, sentiment, fundamentals and decreased sensitivity to external variables (or improvements abroad).

To be sure, we are still in a bear market until clearer signs of the bottoming phase sets in. Here is what we wrote, during the latest bounce last March in Missing Rallies or Catching A Falling Knife?

``Remember, bearmarkets draws in hopes of investors until they capitulate. If a decision has been made to enter the market today, then the expectation should be geared towards the longer horizon since the risks is likely tilted towards more potential downside actions or the risks of a portfolio going underwater. For me, trying to bottom fish or picking market tops is a game of vanity.”

So again have we been wrong with the cycle?

Stock Market Investing and Financial Sorcery

``We are all faced with a series of great opportunities brilliantly disguised as impossible situations."- Charles R. Swindoll, American Writer and Clergyman

To some the notion of the role of analysts or money managers is a job similar to the practice of sorcery, where we try to divine the future with tarot cards, mystical spells and arcane rituals or to its financial equivalent-with Greek ‘secret’ formulas or complex math algorithmic models or that what we say or write about should happen instantaneously or that our role is to know entirely the causalities of the marketplace, or identify market tops and bottoms, all of which should be translated to “alphas” or outperformances in our stock selection. In short, the expectations of supernatural power of clairvoyance applied to stock selection.

For me, this signifies the problem of a risk reward outlook based on cognitive biases of anchoring and the availability bias, where anchoring or focalism is a cognitive bias which describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions (wikepedia.org). A basic example is when one reads or gives too much weight into the recent markets activities (declines or losses) as an eternal trend, without considering the phases of market cycles. (If you think the Phisix will return to 1,000 then go ahead and sell.)

On the other hand, availability bias is a human cognitive bias that causes us to overestimate probabilities of events associated with memorable or vivid occurrences. Because memorable events are further magnified by coverage in the media, the bias is compounded on the society level (wisegeek). Example, when we read the cumulative negative gloomy headlines (from politics, rice crisis and rising prospects of a US recession) coupled with signs of declining markets then the probable tendency for impulse driven participants is to flee from the financial markets on the expectations of more bad news that would further drive down equity prices.

So a combination of “anchoring” into today’s market performances compounded by media generated fears or the “availability bias” may lead to an overestimation of risks while at the same time underestimating rewards.

Well if we apply this to the US; its markets have been plagued with a litany of dreadful news, events and developments-such as tightening lending standards, rising incidences of foreclosures and bankruptcies, falling housing prices, increasing costs of financing, retrenching consumers, diminishing trend in corporate earnings, repeated bout of seizures in the credit markets, soaring commodity prices, accelerating consumer prices-yet its major benchmarks have still been trading sideways instead of a “collapse” so far.

This has been defying the predictions of well oiled articulate arguments of bearish analysts. (Yes, admittedly my risk bias is tilted on such outlook, thus the aura of cautious investing).

But can the bears be right? Of course, but risk management depends on how one allocates his portfolio and the risk instrument used under the prevailing market cycle.

The Difference of the Analysis of Market Cycles From Stock Selection

We had been lucky enough to have predicted the rise of the Phisix in 2002, the renascence of the Philippine Mining industry in 2003, the Peso’s reversal in 2004, the US housing bust in 2006, the rise of soft commodity prices or Agriculture commodities to even the Phisix bear market in early August (see Phisix: Undergoing A Cyclical Bear Market Within A Secular Bull Market Cycle?). Therefore much of the major cycles were firmly under our grasp.

Of course I had some blips too. For instance, I even got teased for “panicking” out of the market at the first sign of a meltdown in July when the market sharply recovered into October. Obviously from the privilege of the hindsight, October proved to be a classic Bull trap which basically validated our July-August view. Unfortunately “pressures” to participate in rallies compelled some risks positions, which have now been adversely affected by the recent declines. The good news is that some segment of cash which had been raised during the initial selling was kept as insurance against adversity and now serves as buffers for opportunities.

Yet as you can see, reading market cycles is starkly distinct from stock selection.

Remember stock market investing is a complex task. The financial marketplace is basically a collective psychology of thousands of participants whose decisions are weighed by diverse variables…in the stock market-from mere emotions, tips from friends or brokers to syndicated moves by stock market operators to calculated engagements by institutions. Thus, the attempt to read the minds of these participants is the equivalent practice of financial sorcery.

If a stock/s does not reflect the performances of any representative benchmark such does not imply that it is always blessed or condemned to either outperform/underperform forever. Remember, reading past performances into the future is never a guaranteed outcome. While history may have some guidance, they may occasionally diverge.

In addition, while the performances of stock markets here or elsewhere are driven by its own cycle, this is not a simple task because stock market cycles are underpinned further by the intricate interplay of a host of other cycles (psychological, economic, business, credit etc…).

That is why I pay heed to Mr. Edwin Lefèvre’s a.k.a. Jesse Livermore quote as my stockmarket meme (highlight mine),

``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Mr. Livermore implies that performances of individual stocks depend on the whereabouts of the general stock market cycle. How true this is? Today, under this interim bear market cycle, we can name only a handful of stocks still trading at the near peak (of not less than 20% decline). So his assertions are more valid in general than otherwise.

Moreover, individual stocks are likely to perform under their own distinct functionalities given the above premise- it could be driven by mere emotions, corporate developments or fundamentals, insider activities, technical or by a consortium of stock operators or by anything else.

In other words, attempts to identify all these short term variables consistently are beyond my or anybody’s ken. It is nearly an impossible task.

All we know is that especially applied to the Philippines, whose market is way underdeveloped, when the stock market is bullish people conjure up all sorts of (mostly invalid) reasons to participate in rising stocks regardless of risks. This applies inversely to falling markets. Thus, expectations to predict which stock issue would move next, or would serve as the next “favorite”, or attempting to time markets for tops and bottoms is a futile exercise equivalent to financial sorcery.

Again from the legendary trader Jesse Livermore ``It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight. Men who can both be right and sit tight are uncommon. The market does not beat them. They beat themselves, because though they have brains they cannot sit tight."

Bottom Line: We are NOT in the practice of financial sorcery. We cannot identify the next crowd favorites. We invest out of risk reward tradeoff concerns, where present declines appear NOT to entail a reversal of the long term trend but instead reflects on the interim countercyclical trend amidst a secular bullish trend until proven wrong. Nonetheless, we are NOT impervious to mistakes or losses as risk taking is NOT about perfection or the ability to predict winners consistently but one of reducing risk and optimizing gains. We must remember that since markets operate on cycles, no trend goes in a straight line. Impatience guarantees underperformance.

Finally, the major force of ANY asset boom-bust cycles is rampant speculation driven by excessive monetary inflation and massive credit expansion. There are not enough indications of such excesses permeating into the domestic stock market or to the domestic economy. Not yet anyway. Moreover, such stimulus have not driven the stock market levels to euphoric stages or equally have not yet posed as systemic risks to the economy. Therefore, the present decline is unlikely a long term trend reversal.

Given the present environment of fear, as our favorite icon, Warren Buffett once said ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised."

Negative Real Rates Fuels Boom Bust Cycles And Enhances Inflation Dynamics

``Inflation is like sin; every government denounces it and every government practices it."- Frederick Leith-Ross (1887-1968) civil servant and international authority in Finance

Asset boom bust cycles under the paper money standard have principally been driven by monetary or credit inflation which are further stoked by unbridled speculation or investor irrationality.

This from George Soros, ``Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available.”

In short credit is the lifeblood for boom bust cycles. In a boom phase, ease of credit and increasing collateral values engenders a self reinforcing cycle buttressed by an expanded risk appetite. The opposite holds true in a bust phase, tighter credit and falling collateral values is by itself a self feeding mechanism backstopped by a shift to risk aversion.

Today, we have been witnessing the full boom bust cycle playout in the US real estate and mortgage markets. That is why the US government has been lowering its Fed controlled short term interest rates, it has also been widening the range of institutions requiring direct funding access from the Fed, and loosening up of the standards for collateral eligibility as basis for such funding, aside from changing policies needed to accommodate such facility. The aim is restore the ease of credit, restore risk taking confidence and provide a floor to declining collateral values.

In other words, the US has been utilizing expansionary monetary policies, aside from fiscal policies to reduce the negative impact of a bust phase.

And this boom bust cycle has not been isolated to select asset classes as inflationary policies likewise have been affecting consumer prices around the world. Why? Because, while governments can control its printing presses, it cannot control where the money printed goes.

As Dr. Frank Shostak explains, ``increases in money supply lead to a redistribution of real wealth from later recipients, or nonrecipients of money to the earlier recipients. Obviously this shift in real wealth alters individuals' demands for goods and services and in turn alters the relative prices of goods and services. Changes in money supply set in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices.

``Now, the effect of changes in the demand and supply of money and the demand and supply of goods on prices of goods is intertwined and there is no way that one can somehow isolate these effects.”

In other words, when monetary factors are constant, a price increase in a particular good means a shift in relative prices and not absolute prices. For instance, given a typical household budget; if the price of food increases, then the additional income spent on food would cause a diversion away from spending on non-food goods or services. This should translate to a downward pressure on the prices of non-food goods or services.

But obviously since the price of almost every basic goods and services are on the rise this goes to show how the absorption of the inflation dynamics have shifted from financial assets to consumer goods on a global scale.

Figure 2 shows of the real interest rates in the US have spawned the largest boom bust cycle in the US.

Figure 2: moneyandmarkets.com: Negative Real Rates in 2003-2006 and 2007 til present

We have spilled so much ink with negative interest rate. Negative interest rate is when changes to consumer price indices or consumer price inflation are growing faster than nominal rates.

To quote Mike Larson of moneyandmarkets.com, ``When real rates are negative, it's a sign that policy is easy. That can drive inflation pressures and inflation expectations higher. When real rates are positive, it means that monetary policy is restrictive. That, in turn, tends to keep a lid on inflation.”

As we previously wrote, negative real rates deal with the function of money as a store of value or the opportunity cost of holding cash. Negative real rates basically is a policy for dissavings (punishes savers as the purchasing power of a currency erodes via higher consumer prices) and encourages the public to go into debt and venture into speculative activities to preserve the store of value. It gives false signals to the marketplace, and encourages malinvestments. Thus negative real rates feeds on inflation driven asset boom bust cycles.

Figure 2 shows that in 2003 to 2006 real interest rates were kept in negative territory for about 3 years. Today, real interest rates have further plunged into a deeper negative territory since the credit crisis erupted in 2007.

Figure 3 Northern Trust: Housing and Credit Boom Fueled by Negative Real Rates

Chief Economist Paul Kasriel of Northern Trust gave a great presentation on how negative real rates have turbocharged the US housing and mortgage bubbles.

The select charts shows of the (left chart) Market value of real estate as % to after tax disposable income (circle shows of the accelerated trend of home prices during negative real rates).

This leverage build up was equally evident on US houses which had been used as an ATM substitute via a net home equity extraction (circle shows the dramatic expansion of credit during said period).

Figure 4: Northern Trust: US Current Account Deficit Exploded While Bank’s Mortgage Business Boomed

Figure 4 again courtesy of Northern Trust shows how US banks capitalized on the Mortgage boom by dramatically expanding the share of mortgage assets to total earnings (right chart) again during the same period.

Current account deficits reflected the pace of US household borrowing. Again the left chart of figure 4 demonstrates how the pace of deficits expanded rapidly as US households borrowing boomed, again under negative real rates.

The lesson that can be drawn from this is that as inflation pressures seems apparently building up around the world (China and GCC continue to amass current account surpluses) especially with the present deep negative real rates in the US.

Negative real rates are likely to fuel either a bubble in some asset classes (most likely in commodities or commodity related assets) or could be passed off or transmitted through higher consumer prices.

The Philippines is likewise under a negative real rate climate, hence, the rice crisis could be a possible manifestation of this phenomenon backed by skewed policies.

Further, as we have been saying all along, I wouldn’t exactly shut the door for a potential recovery in the Phisix, especially on commodity related issues. While it may take time, increased speculation utilizing liquid assets backed with potential stories (yes remember markets operates on biases which for stories!) should be good candidates for today’s alternative store of value.

Mises.org: Economics 101: The Price of Gas

Occasionally we come across analysis or missives dealing with high gas prices to tangential issues.

However, this terrific 591 words article by Mr. Sterling T. Terrell published at the Mises.org is a concise and incisive encapsulation of the dynamics of today's gas prices.

Quoting Mr. Terrell's entire article (highlight mine)

Gas prices are up and oil executives are once again testifying before Congress. Clearly, many politicians, pundits, and consumers lament the rising cost of gas. Before we join them in their chorus, let us take a step back and ask this question: Are gas prices really all that high?

A change in price can be a result of inflation, taxes, changes in supply and demand, or any combination of the three.

First, we need to take into account inflation. The result of the Federal Reserve printing too much money is a loss of purchasing power of the dollar: something that cost $1.00 in 1950 would cost about $8.78 today. As for gas prices, in 1950 the price of gas was approximately 30 cents per gallon. Adjusted for inflation, a gallon of gas today should cost right at $2.64, assuming taxes are the same.

But taxes have not stayed the same. The tax per gallon of gas in 1950 was roughly 1.5% of the price. Today, federal, state, and local taxes account for approximately 20% of gas's posted price. Taking inflation and the increase in taxes into account (assuming no change in supply or demand) the same gallon of gas that cost 30 cents in 1950 should today cost about $3.13.

Neither have supply or demand remained constant. The world economy is growing. China and India are obvious examples. At the same time, Americans continue to love driving SUVs and trucks. As for supply, we are prohibited (whatever the reasons may be) from using many of the known oil reserves in our own country. Furthermore, due to government regulation, the last oil refinery built in the United States was completed in 1976. In addition, the Middle East is politically unstable which leads to a risk premium on the world's major source of oil. It is obvious that the demand for oil has grown while supplies have been restricted.

The average price of gas in the United States today is approximately $3.25. The question is, why are gas prices not higher than they are?

Blaming greedy oil companies on the rising price of gas is simply irresponsible. The profit margins of a few selected industries are as follows:

Murray Rothbard considered this the best text available on price theory.

The water utility industry has higher profit margins than major oil and gas firms! Why isn't every CEO with profit margins above that of the oil companies made to testify before Congress for "price gouging"? Clearly, greedy corporate profits are not the issue.

Again, while just over nine percent of the price of a gallon of gas goes to oil company profits, approximately twenty percent of the price of a gallon of gas is composed of federal, state, and local taxes.

Those who want the government to step in and do something about the high price of gas are either forgetful of recent history or too young to remember the oil crisis of 1979. During that time, restrictions on the price of gasoline led to the inability of some to find gas at all. Price ceilings always lead to shortages. The only thing worse than having to pay "too much" for gas is not being able to find gas at any price.

Let us not be swayed by politicians out for power or by reporters out to create news where none exists. Facts and economic logic should prevail rather than rhetoric.

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