Cheap Currency Not Always Equal To Undervalued Equity Assets

``A disordered currency is one of the greatest of evils. It wars against industry, frugality, and economy. And it fosters the evil spirits of extravagance and speculation. Of all the contrivances for cheating the laboring classes of mankind, none has been more effectual than that which deludes them with paper money. This is one of the most effectual of inventions to fertilize the rich man’s field by the sweat of the poor man’s brow. Ordinary tyranny, oppression, excessive taxation: These bear lightly the happiness of the mass of the community, compared with fraudulent currencies and robberies committed with depreciated paper.”-Sen. Daniel Webster, during the debate over the reauthorization of the Second National Bank of the U.S. in 1832

Attractiveness of corporate equity asset based on currency changes is relative. It doesn’t automatically mean that foreigners will be attracted to an asset simply because of the singular notion of a depreciating currency. If such is the case then foreign money should be stampeding into Zimbabwe since its currency is losing ground by the minute due to rampaging inflation. Maybe sometime in the future, but perhaps not under a Mugabe regime.

On the contrary, a declining currency usually means higher prices of goods and services or consumer inflation which adversely impacts economic growth or corporate earnings. Perhaps foreigners could be attracted once they anticipate an inflection point following a massive devaluation and or a selloff or both. Think the Philippines in 1985/86, Argentina 1990, Peru and Brazil in 1990.

Dr. Marc Faber in Tomorrow’s Gold (highlight mine) makes an important case where falling currencies proffer great investment opportunities, ``Most investors believe that inflation is bad for financial assets and good for real assets such as gold, silver, diamonds and real estate. However what is usually overlooked is that, in very high inflation economies, at some point, stocks become ridiculously undervalued in real terms and therefore provide outstanding buying opportunities. I call this phenomenon the paradox of inflation: instead of producing high price levels, hyperinflation tend to create extremely low prices as currency depreciation (due to massive capital flight) over compensates for domestic inflation.”

Figure 5: Yardeni.com: Foreign Buying of US Equities

But out of the ordinary we don’t see any strong correlation of falling currencies and rising instances of foreign buying seen in the context of the US markets as an example.

The US dollar index strongly rose from 1995-2002, yet foreign purchases of corporate equities as shown in Figure 5 courtesy of Yardeni.com continued to rise. The US dollar likewise rallied in 2005, yet has seen positive inflows from overseas investors in corporate equities.

On the other hand, the declining US dollar has seen a mixed output. The initial phase consisted of a decline (2002-2004) while the succeeding phase has shown a reversal. In short, many other factors determine the attractiveness of an asset.

For the Philippines whose financials markets is hobbled by high transaction costs, high risk premium, low liquidity, unsophisticated and undeveloped market platforms as major disadvantages among other known risks, we have been quite fortunate –the emerging distaste for the US dollar has prompted for a worldwide search for alternative non-US dollar markets, diminishing global “home” bias supported by real time technological innovation and deepening trade and financial integration (a.k.a globalization), aside from the growing need to improve on the region’s financial markets as conduit to absorb savings and forex surpluses to mobilize capital-has buoyed the attraction of our assets to international investors.

We just hope we don’t shoot ourselves in the foot.

The Global Engineering Boom

The next career hotspot is evidently in engineering.

Major economies as Japan, Germany and Switzerland seem to be running short of Engineers.

This from the Financial Times (emphasis mine),

``Germany, a land renowned above all for its high standards of engineering, is facing an acute shortage of skilled engineers.

``Franz Fehrenbach, chief executive of Bosch, became the latest businessman to sound the alarm when he warned this week that the lack of engineers was “the key problem for the future”.

``VDI, the German association of engineers, believes the shortage is costing Europe's largest economy €7bn ($11bn, £5.5bn) a year and estimates that there are 95,000 unfilled posts, up from half that number two years ago.

``It is a similar situation in some neighbouring European countries such as Switzerland, where there are several thousand engineers lacking.

`` “Our shortage is not as serious as in Germany but it will get worse,” said Marina de Senarclens, head of Engineers Shape Our Future in Switzerland. “One reason is that new sectors such as financial services need engineers, meaning demand is ahead of supply.

`` “On the other hand, countries such as France and Italy are better at producing engineering students.”

``Mr Fehrenbach said for every 100 old engineers, only 90 young engineers were being trained in Germany, compared with an average of 190 in other western countries.

``Manfred Wittenstein, the founder of engineering company Wittenstein AG and the head of the VDMA engineering association, said: “It could act as a brake on our future growth.”

And so it is in Japan.

The ministry of internal affairs estimates that the digital technology industry alone is short by half a million engineers!

The fundamental problem is one of the declining interests by students in the field of science and engineering.

Courtesy of the New York Times

This from the New YorK Times, ``Universities call it “rikei banare,” or “flight from science.” The decline is growing so drastic that industry has begun advertising campaigns intended to make engineering look sexy and cool, and companies are slowly starting to import foreign workers, or sending jobs to where the engineers are, in Vietnam and India.”

In Japan, embracing foreign workers have been slowed by cultural rigidities.

``In the meantime, the country has slowly begun to accept more foreign engineers, but nowhere near the number that industry needs.

``While ingrained xenophobia is partly to blame, companies say Japan’s language and closed corporate culture also create barriers so high that many foreign engineers simply refuse to come, even when they are recruited.

``As a result, some companies are moving research jobs to India and Vietnam because they say it is easier than bringing non-Japanese employees here.” (NYT)

So aside from career opportunities, the obvious alternative is a potential boom in investments in engineering related business outsourcing here (IF we are able to generate enough quality graduates) and abroad.

Private Altriusm

The markets have been charged with many forms of atrocities such as greed, materialistism and uncharitableness and many others. In short, private altruism is not possible…

chart courtesy of the Economist

From the Economist (highlights mine), ``AMERICA'S government is frequently accused of stinginess when it comes to foreign aid: the official sort is just a TINY proportion of annual GDP. But donations from INDIVIDUALS and BUSINESSES are startlingly high. American private giving to poor countries amounted to $34.8 billion in 2006, dwarfing that of other rich nations, according to the Index of Global Philanthropy published on Monday May 12th by the Hudson Institute, a think-tank. An established culture of philanthropy and charity contributes to direct aid-giving, as does a generous tax regime.”

First Test of the Phisix Bottom Thesis: Passed With Flying Colors!

``The true prophet is not he who predicts the future, but he who reads history and reveals the present.”-Eric Hoffer, 1902-1983, American social writer

So far so good.

My suspicion that the Phisix could have probably entered into a bottoming phase encountered its first acid test and appears to have passed with flying colors. In the face of pervasive gloom and doom, the Phisix cautiously bounced back by 2% this week for the first week in five.

Interpretation of Initial Impact and Arguments For A Phisix Bottom Redux

Of course the market’s reaction can be interpreted in two ways;

one- a short term interim technical bounce amidst a persistent medium term bear market or

second- an interim bounce which paves way for a seminal bottom under the perspective of its long term underlying trend. Remember market cycles involves process transitions and is not merely event-driven as incredibly suggested by some “experts”, therefore, the Phisix would have to pass repeated tests in order to reconfirm the validity of the ongoing restoration of confidence process.

We have premised the potential turnaround on a confluence of factors which involves the following:

1. Market volatility.

The recent gains of the Phisix (2.8 times) have not been steep and sharp enough as to merit a similar scale of descent. As an example, in 1986-1987 the Phisix climbed by about 10 TIMES which was correspondingly met by a nasty 50% correction. Similarly as mentioned last week, Saudi’s Tadawul and China’s Shanghai bourses flew by over 5 times in TWO to THREE years and has met by the same degree of volatility on its corrective phase, 65% and 50% respectively. Paraphrasing Newton’s Law, Every action has an almost equivalent and opposite degree of reaction.

2. Bubble cycle.

Every asset classes in today’s paper money driven world have been driven by varying stages of massive credit and monetary expansion. Based on public participation we have not seen evidence of such euphoria or investor irrationality.

Next, our asset markets have not reached extensively rich valuations levels. Lastly, the country’s macro or micro indicators have not signified signs of excessive leverage.

3. Encompassing Negative Sentiment.

Since market activities are driven by the investing or speculating public making decisions for whatsoever reasons- they involve psychology. Thus, market cycles are primarily underpinned by the psychological cycle.

Given today’s dire headlines from the domestic front (rice crisis, government threat of a utility takeover, etc.) to overseas (US recession, world economic slowdown, continuing credit crisis, surging “inflation” in food and energy, etc.), the degree of risk aversion has somewhat reached overshoot levels. Yet actions in the marketplace do not reflect or have not been congruent to the same degree of anxiety as shown in Figure 1.

Figure 1: stockcharts.com: PSE The Outlier!

As global markets have remained as closely correlated as in the past, most of these benchmarks imply that the underlying national indices under such rubric have rebounded since March of this year (vertical line).

The Dow Jones World Market at the top pane, the Dow Jones Asia Ex-Japan Index (below center window) and the iShares Emerging Markets (lowest pane) have recovered substantial losses since October.

Whether this recovery represents a “dead cat’s bounce” or a “bear market” rally is arguable and predicated on the caller’s bias. But the point is the Phisix (at center window) has missed the “gravy train”! Or…so it seems?

But compared to the past rallies which manifested of sharp V-shaped bounces, this time we are seeing some signs of consolidation (circle).

A prolonged consolidation or a gradual ascent should exhibit the recovery’s resilience, but again bottoming as a function of an evolving process within a cycle will mean repeated tests where investor patience and grit amidst prevailing fear should eventually be rewarded.

Yes, we were delighted to see that even as the US markets lost meaningful grounds last Wednesday (by about 2%), the Phisix “diverged” by recording moderate gains Thursday.

We have noted in the past that for the Phisix to reestablish strong indications of a recovery, (see Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom) durability in the form of less sensitivity to external variables should be seen as a guide, aside from progressive technical action, of which both signs seems to have been manifested this week.

Monday should be another test day since the US markets ended the week with moderate losses. Since Mondays are traditionally the weakest day of the week, the Phisix could be subject to some selling pressure following the weakness in the US markets. But for as long as the Phisix keeps the pace of its losses to within the range of losses in the US markets, we should remain in a consolidation phase with a recovery bias.

Dead Calm Waters Reveals Attribution Bias

One must be reminded that betting on future outcomes requires the understanding of risk and reward tradeoffs.

When we talk of a “bottom” we don’t even go near to the suggestion of a mystical formula or some alternative forms of voodoo rituality applied to the financial sphere but one where we distinguish the odds of the probability of incurring more losses against that of the odds of the prospective gains. In simple words, the bet of a bottom means the understanding that the room for further loss is significantly less than for future gains. But this, in contrast to the expectations of market punters, happens OVERTIME and requires PATIENCE.

I might like to add that the negative sentiment have truly reached extremes seen in the ground levels. In a recent social function which I regularly attend, where early this year participants seem agog over the market despite the decline (the assumption is that the market’s decline was short and shallow), today almost everyone seem to shun the topic of the stock market, which for me appears to uncannily resemble the investing atmosphere in 2002, a great window for grabbing outsized returns.

Nonetheless, I gathered that losses for some have been staggering enough to dismiss the existence of the stock market. And some have even fostered acerbity towards the financial intermediary agents (bankers, stock brokers and analysts).

Of course I might be accused of reading the sentiment of a group into the whole (fallacy of composition) but as we previously pointed out market internals, as seen by declining daily trades, have depicted the same picture where speculative froth engaged by mostly retail market participants have substantially ebbed. Since speculators have been caught in long positions due to their inability to accept losses or have been immobilized, trading activities have been restrained.

The lesson here is one of the Attribution Bias, where people tend to take credit on successful endeavors to inherent skills but deny responsibility for failures by imputing situational variables either by “randomness” or by the influences of others to their decision making.

Thus, when the market is buoyant everyone seems to know of the “whys” and the “whats” and the “who-drives-what” in the marketplace, and conversely when the market is dreary, the atmosphere seems like dead calm waters.

Negative Real Interest Rates and Emerging Market Bubbles

4. Negative Real Interest Rates.

Mainstream analysts or experts impute stock market investing to micro or macro events, some deal with the technical aspects. As a contrarian, we see the market as mainly the alternative function of money: a medium of exchange, a unit of account (means for economic calculation) and a store of value.

Not everything can be explained by micro or macro factors. Yet mainstream analysis insists on such lockstep correlation. We beg to differ.

Policies administered by government/s have manifested significant impact to asset prices. That is the reason for the phenomenon of bubbles. Investor irrationality is only an aggravating circumstance to a bubble in formation, because this cannot thrive without the principle of leverage (margin trades or credit expansion).

Following years of monetary accommodation and extensive growth of credit intermediaries of all sorts-derivatives to margin trades to alphabet soup of securitization, the implosion of the housing bubble in the US and other Anglo Saxon Economies has left central banks apprehensive of the negative economic growth impact from declining asset prices. As such, monetary authorities have mostly left policy rates lower than instituted “inflation” benchmarks hence negative real rates. Aside, they have been conducting massive liquidity bridging operations and applying fiscal subsidies in support of consumers suffering from the string of recent losses. We have explained most of these in Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

In addition, monetary pegs and mercantilist trading structures of key emerging markets have apparently resulted to a globalized mechanism for transmission of inflationary activities whose effects are now ostensibly rechanneled from Wall Street securities into commodities and emerging markets.

This insightful excerpt from Prudent Bear’s Doug Noland in his Credit Bubble Bulletin (highlights mine),

``prevailing inflationary pressures are global in nature. Wall Street finance is the source fueling the boom, and it’s running outside the Fed’s control. American asset inflation and resulting wealth effects are minimal, while price effects for food, energy, and commodities are extreme. In contrast to previous inflationary booms, while some selected groups benefit, the vast majority of people today recognize they are being hurt by rising prices. This hurt comes concurrently with atypical housing price declines. Today’s price effects pummel already weakened consumer sentiment, as opposed to previous effects that tended (through asset inflation) to bolster confidence. Furthermore, current inflationary forces are destabilizing and even destructive to many businesses, while playing havoc with the fiscal standing of federal, state and municipal governments.

``Revolving around booming Wall Street finance, previous inflationary booms naturally fueled surges in securities issuance and speculation. These Bubble Effects worked as powerful magnets in attracting foreign financial institutions, foreign-sourced speculators, and cheap foreign-sourced borrowings (i.e. yen borrowings financing higher-yielding U.S. securities) that all worked in concert to “recycle” our Current Account Deficits (“Bubble dollars”) directly back to our securities markets.

``In contrast, today inflationary forces largely bypass U.S. securities to play global energy, commodities, and hard assets. Foreign financial institutions are fleeing the U.S. risk intermediation business, while “Bubble dollars” are chiefly recycled back into Treasury and agency securities (where they now have minimal effect on U.S. home and asset prices). Meanwhile, the massive global pool of speculative finance is today focused on energy, commodities and the “emerging” economies.”

In short, what you are witnessing today is an ongoing massive shift in the inflation bias or bubble progression on a global scale from securities to commodities and to emerging economies.

Figure 2: stockcharts.com: Soaring Commodities and Latam Bourses!

Look at today’s commodity and commodity affiliated markets (see figure 2): Oil at an ALL time high $126 per barrel! The CRB Index is also at a Fresh record high! And commodity heavy benchmark of Latin American bourses (Dow Jones Latin America) also on record!

A world of negative real rates is likely to buttress such powerful dynamic. What you will likely have is a phenomenon of funds chasing winners which should spillover to a broader spectrum of commodity associated assets (yes we are seeing signs of the emergence of Ponzi financing in commodities), hence the bandwagon effect in motion!

While the impact of such inflation bias will always be unequally distributed between producers, sellers and buyers of commodities as discussed in my previous blog, Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline, the Philippine economy as an erstwhile major commodity exporter is a strong contender to be a beneficiary from the globalized inflation machinery.

Figure 3: PSE subindices: Recent Recovery Primarily Driven By the Mining Sector

Incipient signs of such rotation have already surfaced.

While the Phisix remain depressed down 23.25% year to date as of Friday’s close, the mining index (equally down 16.5%. y-t-d) has seemingly bottomed since March and has gradually been in consolidation and now seen moving higher-see figure 3 (Japanese Candlestick). This comes after a 6% jump this week, mostly from Atlas Consolidated which has soared by 25%! You don’t normally see a 25% run over a week from an index heavyweight (second largest weighting in the mining index at 16% after Philex) especially in a BEAR market! This only strengthens our case that the Phisix will likely recover soon.

And given that both the above technical picture plus the developments in the world market strengthened by a negative real rate environment, it is likely that the mining and oil sector will lead the Phisix’s recovery over the coming sessions.

All other indices in the chart are underwater on a year-to-date basis, this includes Banking (blue) down 19.75%, Commercial Industrial (violet) 20.59%, Property (red) 29.95%, Holding (green) 27.62% and Services (orange) 19.82%.

Moreover, investors will always find justification for an investment theme. Economic growth supported by capital investments over a dominant asset class is likely to become a feedback loop in a self reinforcing bubble cycle.

Figure 4 GMO: “They have the growth. We don’t. What’s to discuss?”

As the sagacious fund manager Jeremy Grantham of GMO (Jeremy Grantham, Richard Mayo and Eyk Van Otterloo) recently argued in his outlook, historically bubbles would need a strong underlying fundamental case from which the bubble is anchors upon.

In terms of emerging markets as shown in Figure 4 it is likely to be found in the consistent outperformance of economic growth. In the poignant words of Mr. Grantham, ``They have the growth. We don’t. What’s to discuss?”

Like us, Mr. Grantham believes that the next bubble will be on emerging markets. Quoting at length Mr. Grantham (all highlights mine),

``For one, emerging will increasingly be seen on a country-by-country basis. Nevertheless, the second wave of let’s-look-like-Yale money from state plans is still in its early stages and looking to invest overwhelmingly in emerging market funds, not in the specific country funds of the Yales and Princetons.

``For another caveat, the GDP growth rate of a country does not in the very long term necessarily determine how much money a country’s stock market will make. Long-term market return may depend more on profit margins. But investors believe GDP growth really matters, and Japan went to 65x earnings despite average or lower corporate profit margins.

``But the third caveat is the most serious; this emerging bubble can easily be postponed or even stopped before it really begins by the current financial problems and the slowing growth rates of the developed world that are likely to follow.

``My own view is that our credit problems will impact and interrupt the recently sustained outperformance of emerging in the intermediate term, say, the next 3 years, even as the acceptance of this emerging bubble case grows. Such interruptions may be quite violent but, despite them, at the next low point for the U.S. market the emerging markets are quite likely to do no worse and in the recovery they will go to a very large premium. And if, just if, the U.S. gets very lucky indeed and muddles through without serious market and economic problems, then the emerging bubble will of course occur more quickly and smoothly.”

Phisix: Political and External Risk Variables

So yes, allied with the views of Mr. Grantham as we have previously mentioned, the Phisix is envisaged by two major risk factors; one is domestic political risk and the other is the transmission factors of the external risk environment.

Political risk could be associated with the risk of destabilizing markets through populist policies such as overextending subsidies to reverse the gains or improvements of the country’s fiscal position and balance sheet, combined with threats to the sanctity of private property ownership via “nationalization” or management “take over”.

So when we read of canards repeatedly circulating in the emails of “why the Philippines is poor?” we understand that it is the fundamental aspect of principally NOT having ENOUGH capital investments in the country and NOT because of lack of “moral” leadership why the Philippines is “poor” (yea ironically the Philippines is “poor” but home to 3 of the 10 world’s largest malls and growing!).

It is because of the lack of appreciation of the markets through property ownership and the enforcement of contracts, the lack of savings, a dearth of platform or infrastructure for establishing pricing efficiency, the lack of competitive environment, a politically dependent society or culture and importantly the high costs of political intervention and bureaucracy.

Remember the popular personality based politics theme of corruption represents a symptom and NOT the disease. Corruption basically is an offshoot to suffocating network of bloated bureaucracy as a result of overregulation and inordinately high taxation due to huge liabilities accrued from failed policies and deep dependence on political gratuity (a.k.a. pork barrel).

Economics 101 tells us that the more you want of something you LOWER the costs, in contrast, the less you want of something you INCREASE the cost. If you want to lessen the incidences of corruption you increase the cost of committing corruption. If corruption is an offshoot to overregulation then streamlining of laws, reduced bureaucracy and lower taxation should be encouraged aside from strictly enforcing laws.

In addition it is NOT governments that drive the wealth of economies or responsible for the upgrading of the standard of living of societies, otherwise communism (Stalin’s USSR, Mao’s China, Kim’s North Korea, Castro’s Cuba) would have succeeded; it is the people!

If governments empower its people to conduct trade openly with LESS political intervention thereby strengthening the division of labor within its economy then it reduces the country’s risk premium, lowers the hurdle rate, reduces the cost of doing business and thus becomes competitively attractive for capital investments.

Governance permissive of a market economy or an entrepreneurship culture and less dependence on the political leadership is the common denominator of successful economies. Because it is a governing policy to limit government’s intervention then the issue of “moral” becomes moot.

But when you see the leadership use its coercive power of its legally clothed leviathan to conduct political harassment or render vindictive actuations on presumed political opponents in the name of public services then it raises questions among potential investors about the sacredness of equity ownership.

This in itself increases the cost or barriers of doing business. Hence capital would seek a hefty premium in terms of higher rate of return or yields for it to consider deploying them into the country. The higher the costs the lower rate of investments.

These incessant political interventions is the reason why the Philippines will remain politically and economically disadvantaged and will thus depend on the global or regional cycle for its upliftment than from intrinsic factors such as the popularly demanded (but largely ineffective) “government driven” initiatives instead of the unpopular market oriented reforms. To quote Ludwig von Mises, ``The effect of its interference is that people are prevented from using their knowledge and abilities, their labor and their material means of production in the way in which they would earn the highest returns and satisfy their needs as much as possible. Such interference makes people poorer and less satisfied.”

As for external risk variables, the country is faced with the same macro risks as the others, a sharp US recession, a steep global economic slowdown, accelerating inflationary policies which could fuel the intensity of the present bubbles and or goods and services inflation, geopolitical risks of public upheavals (triggered by food crisis) or potential military conflicts (over resources), a US dollar crash, global depression and other fat tails.

Phisix, Inflation and the Available Bias

``While inflation is a growing problem for Asia's developing countries, it is not necessarily the region's biggest threat. Rather, the looming risk is the potential for governments to react poorly to inflationary conditions in a bid to quell popular dissatisfaction. In the process, poorly construed policies may actually exacerbate, rather than alleviate, inflationary conditions.”-Matthews Asian Fund

And another thing, one of the factors attributed to Tuesday’s decline in the Phisix was due to “rising inflation”.

For us, this serves a vivid example of the application of the available bias to stock analysis or news reporting.

The inflation figures reported by the newswires dealt with April figures. Why should a market react to past records, unless they think “goods and services” inflation figures will worsen now?

One must be reminded that the market functions as a forward discounting mechanism. Hence estimated actions are based on potential outcomes and not on past records.

Second, “inflation” data always lags. Inflation data captures “lag” responses to government policies or to shocks in an economy.

Third, there is no strong correlation between the performance of stocks and inflation as shown in figure 5.

Figure 5: IMF Staff: PSE and Inflation Over 6 Years, Correlation Where?

Courtesy of IMF’s April Consultation Staff Report the chart shows that over 6 years there has been NO direct correlation between the performance of the Phisix and Philippine “inflation” benchmarks.

Soaring inflation in 2003-2005 did not stop the Phisix from doubling, whereas the declining “inflation” coincided with a steepening of the Phisix gains of 2007. The operative word is “coincided”.

Our idea is that stock markets serve as a repository of company assets (tangible and intangibles) which accounts for potential diversity of treatment by investors given the current “goods and services” inflation landscape.

Since there is no firm correlation to “inflation” and the “Phisix”, hence ascribing “inflation” as deterrent to advancing stocks is simply an excuse or justification based on available news used to explain unrelated events. Thus, the available bias. The fact that the Phisix climbed by 2% over the week debunks such imputation.

Maybe journalists and mainstream analysts should explain why and how hyperinflation (165,000%) in Zimbabwe has been “beneficial” to stocks (360% in Three weeks or 4,000 % from January to April 28^th)?

$200 oil?

This from the Economist,

“OIL briefly reached another record on Tuesday May 6th as West Texas Intermediate traded at over $122 a barrel for the first time. Ten years ago a barrel fetched around $15. The feeble dollar, soaring demand and supply constraints have all helped to push up prices by 25% in the past four months alone. And there is little sign of respite for worried governments and consumers. This week Goldman Sachs, a bank, predicted that oil could reach $200 a barrel before the end of the year.”

Chart courtesy of the Economist

Oil just recently set a new record at $123.93.

For as long as government intrusions seen in many faces (price subsidies, supply “geographic” restrictions, nationalizations, massive credit expansions, currency debasement policies, high taxes, “strategic petroleum reserves”, et. al.), persist to distort market mechanisms, oil prices will continue to ascend (perhaps even more than $200) until demand crumbles. Eventually the market determines the outcome.

Will Internet TV Be A Dominant Trend?

Internet protocol television (IPTV) seems to be gaining ground worldwide.

chart courtesy of the Economist

This from the Economist...

“NEARLY a third of Hong Kong's households watch television via the internet, according to a new report from Telecommunications Management group, a consultancy. Because internet protocol television (IPTV) uses the same technology as that which links computer networks, smaller countries with high broadband penetration tend to have more subscribers. As well as plain old programmes, viewers can also enjoy other services such as on-demand video. So far, Europe accounts for over half of the world's subscribers.”

Inflation Data Brings Philippines Into Deeper Negative Real Rates; NOT A Likely Cause of Today’s Decline

As expected, Philippine inflation rates leaped to its highest level in 3 years according to the news wires.

Chart courtesy of abs-cbnnews.com: Soaring Philippine Inflation Rates!

The following quote from abs-cbnnews.com, ``The price of rice, a staple in the Philippines, soared in April by nearly 25 percent from a year ago. Overall food prices rose 12 percent, the National Statistics Office said on Tuesday.” (emphasis mine)

Earlier mainstream analysts primarily attributed the rise of our inflation index to higher oil prices from which refuted in our March 5 post, “What we have been saying is that the surge in global commodity prices, which appears to be reflected in food prices, is likely to be more strongly associated with the recent uptick in our price index data than oil alone.”

And this was even prior to the emergence of the “rice crisis”. Now it appears that our view has been validated anew!

Remember the so-called inflation index is a LAGGING indicator, again to quote abs-cbnnews.com (highlight mine), “The Philippine’s annual inflation jumped to a near three-year high of 8.3 percent in APRIL, putting pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth”.

And implying stock market price movements based on a lagging indicator does not reflect the functionality of markets as forward discounting mechanism. Does the April data mean the same, better or worst for today?

In short, any attribution to inflation of the past as determinant of today’s market decline is all about “rationalization” or looking for a simplified explanation into today’s activities.

Notwithstanding, if inflation had been the “casual” agent responsible for today’s decline, why does it seem that even “inflation hedges” have been affected too?

The meat about the argument of inflation being a negative for the market is about pressures on corporate margins. Higher input costs and limited consumer pass through or pricing power crimps on corporate profitability. But this should not hold true for existing producers of commodities who are likely to benefit from rising values of “commodity products”.

It also means pressure on consumers in terms of declining standard of living.

An example would be this quote from Standard & Poors,

``In the world of higher commodity prices, corporate winners and losers fall into two distinct camps.

``Commodity producers are big beneficiaries. Their business outlooks appear generally strong and their ratings stable, in our view, as scarcity and worldwide demand affect everything from corn to copper. But companies that rely heavily on grains, oil, or other commodities to make finished goods face increasing costs, and thus weaker profits, if the slowing U.S. economy makes raising prices more difficult.

``The fallout from high commodity prices will be unequally distributed and determined by whether one is a buyer or seller of commodities. The level of commodity input into finished goods and the ability to raise prices will determine how serious the impact will be for commodity users. Low steel costs, for instance, are certainly better than higher costs for automakers. But steel is a relatively small part of a car's cost, and the woes of Detroit's Big Three (oil prices and labor costs, for example) go far beyond steel prices. Baked goods, cereals, meat, poultry, eggs, and dairy products all contain, directly or indirectly, large amounts of corn or wheat, so the impact of higher prices for those grains is widely felt among food processors. And the high price of oil will clearly be deleterious for industries like refiners or airlines, where oil is a major input.”

So when we see the market down with commodity producers similarly impacted, it is unlikely to be “caused by” inflation. Instead, it is likely caused by negative sentiment with all “excuses” lodged into it.

Moreover, if one notices the big drag to the sentiment today seems to emanate from the 8.28% decline of Meralco. While indeed Meralco stands only at 3.4% weighting of the Phisix, the purported action by the government to threaten a “takeover” if not a “change in management” is enough to create a pandemonium. Why? It is all about using populist politics as a cover to apply political vendetta or harassment. When government threatens (directly or indirectly) to “nationalize”, private ownership is compromised and thus, leads to destabilization.

Lastly, the world is into an inflationary boom. Inflation by the definition of a surfeit of money creation, massive credit expansion and re-intermediation, aside from spectacular speculative excesses.

The odd thing is that while we cheer the authorities to “save” the financial assets from being overwhelmed by market forces, paradoxically we jeer at the prospects of rising “product” prices when these systemic leveraging have mainly been responsible for the increased claims against limited resources, or too much money chasing too few goods.

No, product inflation will NOT move in a straight line. But for as long as people expect governments to provide more subsidies we should correspondingly expect such trend to be reflected in our way of living.

Further, on the account of the domestic scene, it will “pressure on the central bank to raise borrowing costs despite the threat that could pose to economic growth” as the report says.

This is what we wrote last April 6,

``As we have repeatedly said, negative real rates will likely trigger more speculative activities as the search for the alternative monetary function of “store of value” intensifies. This further reinforces more “inflation” within the domestic economic and financial system.

``So we may likewise expect the domestic central bank, the Bangko Sentral ng Pilipinas (BSP), to raise policy rates to keep up with rising treasury yields (falling bond prices)…

``Otherwise maintaining present rates amidst surging consumer price could lead to negative real rates across the entire yield curve, which should further aggravate the opportunity costs of holding cash.

``On the other hand, rising yields could lead to resurgent foreign capital portfolio flows predicated on currency yield spread arbitrages or carry trades."

So as the Philippines go deeper into NEGATIVE REAL RATES at the expense of savers and for added stimulus for borrowing and speculation, the BSP will be forced to raise rates. But contrary to expectations of further declines, rising yield spreads could as mentioned above entice foreign money into the markets which could increase inflation pressures.

Remember stock market investing cannot solely be explained by sheer earnings or economics (as previously explained), because it also reflects the function of money as a store of value.

chart courtesy of Wall Street Journal: OECD consumer prices

So even when the world (or OECD) has seen resurgent consumer price inflation…there seems to be no strong correlation about rising inflation and declining stocks yet.

chart courtesy of stock charts.com: Dow Jones Developed World Index

The Wall Street Journal Chart shows inflation accelerating in developed countries during the last semester of 2007 (red ellipse) even when the credit crisis was in the process of unraveling.

Yet, even as the appearance of a “peak” in inflation (based on the chart-but I don’t believe it has peaked), stocks has apparently recovered (which for some, signifies as a relief rally) in the backdrop of a “normalizing” US 10 year Treasury Yield.

Phisix: No Bubble! Time for Greed Amidst Fear

``So much of what we hear and what we're taught turns out to be false on closer scrutiny. Whether it is expert advice, what you read in the paper, or what your mother told you, if it is important, take the time to figure out for yourself whether it is really true.”-Steven D. Levitt, Co-Author of Freakonomics, on Figuring Things Out for Yourself

True to the functional transitions of the psychological cycle underpinning the general market’s direction, emotions have been sweeping away rationality like clockwork.

Some Signs of Psychological Capitulation!

Where in a downside cycle, mid stage characteristics as “desperation” and “panic” segues into the finale phase of “capitulation” and “despondency”, some market participants seem to have evinced symptoms of outright dejection by undertaking redemptions, or have utterly avoided or have completely lost interest, while others have even resorted to faultfinding.

These in conjunction with inordinately depressed market sentiment indicators and fundamental developments seem to reinforce our view that Phisix is likely to be nearing a bottom or could be in the inchoate juncture of a bottom formation in contrast to the mainstream thinking.

The basic problem for any investor is forecasting the future accurately. In determining the potential outcome of the markets, if the experts are vulnerable enough to fall for cognitive biases (heuristics or mental shortcuts), thus, it is natural to expect the public (who do not apply rigorous analysis) to give weight to the present direction of the ticker tape activities as the future outcome (recency bias). Yet unknowingly to latter, such biases could be detrimental to the performance of one’s portfolio, if not one’s health (physical or mental) or to relationships.

For instance, when the trend is up, the proclivity is to plough into the market using ANY justifications (available bias) while ignoring risk factors. Peer pressures lend to “missing or chasing the rally” attitude and the need to be “IN” popular trades, all of which expands risk taking activities while reducing returns.

“Experts” are expected to possess the magical powers of the Talisman to predict the next market darling. With the use technical instruments, the public is lured to catch short term “tops and bottoms” from which the legendary Jesse Livermore cautioned everybody wants “to get something for nothing”.

And when the trend is down, the hope of recovery dims, risk aversion grows while the appetite for financial voodoo vanishes, condemnation and depression eventually governs. This is the unfortunate, unpalatable and revolting realism of the marketplace; people simply get what they deserve.

This is where we would like to differ. As we have repeatedly argued, our observation is that long term trends in every asset cycle are basically determined by the Inflating or Deflating of Bubble cycles, operating under today’s monetary “paper money” framework.

Yes, despite the realization of an unfolding bear market today, our belief is that the long term cycle remains grounded in the ADVANCE phase and today’s decline accounts for a cyclical speed bump on the following premises:

1. There are NO signs of a local bubble yet.

2. Every asset boom bust cycles are determined by expansive growth or reversals of frenetic speculation powered by an overdose of leverage from massive credit and or money expansion. We don’t see them yet in the Phisix or the Philippine Economy.

3. The long term risk reward tradeoffs in the markets greatly depends on understanding the dynamics of how the bubble cycle impacts our investments and correspondingly applying such knowledge to balancing our portfolio, profitably.

Parabolic Prices In My Dreams

Today’s bear market is likely to be a temporary phenomenon. Why? Because the Phisix has climbed only by 2.8x from trough to peak in FOUR years (June 2003-July 2007) as compared to the recent experiences of Saudi’s Tadawul and China’s Shanghai Composite (see linked charts) which has exploded by 5.7x and 5x in just TWO-THREE years.

Why the indices of China and Saudi you ask? Because these bourses have exhibited exemplary volatility, in terms of speed and velocity and the duration and scale of movements, which has almost replicated a bubble’s behavior.

Yes, while China’s bourses have suffered from a steep decline (have lost nearly 50%), it has made an astounding rebound over the past two weeks. Meanwhile, despite the abrupt drop of about 65% from its zenith in February 2006, Saudi’s Tadawul seems visibly bottoming out after more than a year of consolidation and looks forward to the next wave up.

What seems to be noteworthy in the activities of both bourses is Newton’s third law of Motion at work, ``Every action has an equal and opposite reaction”.

The lesson is pretty clear: the magnitude of volatility reflects the scale of momentum swings-SHARP SPIKES EQUAL DRAMATIC DECLINES!

However, if we are to examine the phenomenon of how a bubble evolves, we can discern that the action of these bourses as possibly still in a bullish phase over a long period.

Figure 1: Moneyweek.com: Stages In A Bubble

Figure 1 courtesy of Dominic Frisby of moneyweek.com depicts of how bubbles in asset classes develop and unravel.

As you can see from the above diagram, ALL bubbles undergo transitions from the STEALTH phase to the AWARENESS phase to the MANIA phase to the BLOWOFF phase.

This means that incipient trends are generally unrecognized or incubated in a “stealth” phase and are seen or engaged only by a few contrarians “smart money”. As the trend gets accepted or reinforced, this draws in more institutional participants or the awareness phase.

The trend eventually gets a wider audience, but gets tested (First sell off or the bear trap).

Following a successful test, the “tipping point” has now been attained as evidenced by deepening convictions which eventually leads to a broadening of the participation from the general public, bolstered by media as the market transits to the mania phase.

Enthusiasm or cautious optimism then morphs into greed, excessive risk taking, feelings of infallibility or overconfidence and the delusions of permanent grandness or the proliferation of infamous equivalent phrases of “this time its different” or “new paradigm”, where deep-seated convictions clashes with realities. This represents as the Blow-off phase.

Eventually a climax is reached, reality pervades, the house of cards fall under its own weight (or prompted by policy shifts) and the bubble pops. The whole cycle goes into a full reverse.

So where is the Phisix today, according to the bubble cycle?

Figure 2: Phisix’s Monthly: First Major Test?

First, let us use the past cycle of the Phisix as an example as shown in Figure 2.

In the 1986 to 2003 cycle (blue frame), the Phisix entered into the awareness phase in 1986 and encountered its first major test which was apparently triggered by an aborted coup d'état attempt at Camp Aguinaldo in 1987. The next “test” came with another botched coup attempt in December 1989 at Makati. Both “tests” incurred losses of nearly 50% spread over 1-1/2 years before recovering.

What happened after the “tests”? The Phisix skyrocketed by 458% in three years (1991-1994)!

When the Asian Financial Crisis scourge hit the Phisix, we saw the same dynamics as seen in the Saudi-China’s model, Newton’s “Every action has an equal and opposite reaction” in motion. The Phisix lost more than two thirds of its gains, bounced back ex-post the Presidential elections and excruciatingly returned every gains it accrued during the bounce, over the next three years or until late 2002 to early 2003.

Today, following the completion of the full cycle, the Phisix appears to be in an awareness phase which seems to have met its first acid test or its baptismal resistance or its bear market trap after FOUR years, see again figure 2.

This means that if I am correct about the interpretation of the next phase of the Phisix, it is likely that once the recovery gets a firm footing, the next velocity of gains will eclipse the performance of 2003-2007. Think about it, if the Phisix should repeat its past 400% gains from present levels, this means that the Phisix should reach more than 13,000, way above my 10,000 forecast!

No Signs of Public Exuberance or Euphoria

Next, another prominent feature of a bubble is pubic exuberance.

As shown in our bubble diagram, each of the phases exhibits different types of investor involvement.

The stealth phase attracts SMART Money or the Contrarian players (remember our Phisix 2002, mining in 2003, Peso in 2004), the awareness part draws in INSTITUTIONAL money and lastly, RETAIL investors jump on the bandwagon in a MANIA which then leads to the final BLOW OFF phase.

We have seen this happen in China just recently before the “bubble popped”, where 250,000 new accounts were opened daily by retail investors including maids (estimated 99 million new accounts in 2007-sovereign society)!

Have we seen a profusion of public participation as manifested by a massive influx of retail players? I doubt so.

I have previously shown this chart in my outlook.

Figure 3: PSE Daily Trades: Best measure of Local Speculative Activity

We don’t have data on the opening of number of NEW accounts, but we can have a rough approximation of retail activities as signified by the number of trades.

Since retail investors tend to be short term players, my impression is that the rising trend of the daily trades reflects on the speculative activities of retail investors.

As shown in Figure 3, although yes, there had been some signs of a build up of speculative activities from mid 2006, the momentum was easily quashed triggered by the global credit crisis in 2007.

You have to remember that the Phisix climbed from 2003-2006 by about 127% with daily trades drifting within a range. This supports the view that the Phisix has been gradually wended from the stealth phase to the awareness phase where buyers were mostly from “smart” money camp.

Thus, this implies that even before the Phisix bubble took off, it popped! The Phisix Bubble has effectively been deferred! Seen in a different light, this process should even be more beneficial to us, since it gives “smart” money a second major opportunity to build up on our portfolio to take advantage of depressed retail sentiment which should lengthen the bubble cycle and proffer marvelous opportunities of outsized profit returns!

No Evidence of Excess Leverage

Third, ALL bubbles are driven by excessive leverage from massive credit and or monetary expansion.

Think of the Phisix and the Asian crisis in 1997, 2000 Nasdaq dotcom bust, 1990 Japan’s stock market and real estate bubble bust, the US housing bust in 2006 and the commodity bust in 1980 to name a few. The common denominator has been a pyramid built on the walls of leverage.

As previously pointed out, we have very miniscule exposure of US mortgage related tainted papers which according to reports figures to only about .2% of the total banking assets.

We also have not seen material signs of ballooning credit or leverage in any of our macro and micro statistics yet (e.g. Real estate loans, stock margins, current account deficits, corporate loans, etc.).

Figure 4: IMF: Asset Price Developments (left), External Liabilities (right)

For instance, external liabilities as % of GDP has been falling drastically (see figure 4 right window), which means Philippine credit risk relative to foreign debts have considerably declined, albeit it remains to be seen how the recent “politicized” policies on the rice crisis will impact this.

However based on past performance this excerpt from the IMF,

`` External liabilities by Philippine residents (as measured by FDI liabilities, gross portfolio liabilities, and other liabilities—currency and deposits, as well as loans) have fallen sharply since 2004. Starting from a level above 90 percent of GDP, which was raising serious sustainability concerns, external liabilities had declined by over 20 percentage points of GDP by 2006. This sharp decline reflects the significant debt prepayments of the general government and corporate sectors (including the highly indebted power sector).”

`` This reduction is particularly stark in comparison with other countries. The Philippines was a clear outlier at the start of the decade. Since then, the Philippines’ total gross foreign liabilities (as a share of GDP) have converged rapidly to the levels of emerging Asia and emerging Latin America., and by 2006 had actually fallen slightly below the averages of both regional groups.”

The IMF in their April Staff report issued this statement (emphasis ours),

``There is no clear evidence of an emerging bubble. Partly reflecting developments in Asia, asset prices have bounced back. However, property prices are still below the 1997 level. Equity market prices have risen faster with the PE ratio reaching 15½ at end-2007. Equity prices have fallen by more than 10 percent during the first three weeks of 2008, now implying a PE ratio well below the worldwide average of 21 during 2001–06.”

So, there you have it…essentially for Philippine assets you have NO EUPHORIA, NO SPECULATIVE EXCESSES, NO OVERVALUATION and NO MASSIVE LEVERAGE! Ergo, NO BUBBLE!

The main market risk today comes mainly from domestic populist politics and from external variables or the transmission effects of a global economic slowdown which could lengthen the entire process but is unlikely reverse the present cycle unless a black swan occurs (possibly from US dollar crisis or global depression or world war).

Heeding Buffett’s Advise: Be Greedy When Others Are Fearful!

Thus we ask ourselves, how can we afford to be bearish when the cycle insinuates that we are still locked in a long term “advance” phase or a bullmarket? Not unless if our horizon is TOO SHORT, as to read in today’s action as an everlasting trend.

Dr. John P. Hussman, Ph.D. of the Hussman funds offers some sagacious advice, ``Good investments are those based not on hope, but on some foundation of evidence – either of reliable “investment merit” (based on properly normalized valuations), or of measurable “speculative merit” (based on the quality of market action). Taking a significant exposure to market risk without such foundations is like moving into a house built on sand.”

We should instead take a cue from the world’s best stock market investor and now the world wealthiest, billed as the sage of Omaha, Mr. Warren Buffett, who appears to have embarked on a buying spree following years of holding a war chest of over $40 billion.

In a lecture at Columbia University at age 21 Mr. Warren Buffett was quoted, ``I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."

Now that we have been seeing many worsening signs of fear, I think it is time to gradually take advantage of such opportunities.