Amidst Market Meltdown: The Phisix-ASEAN Divergence Dynamics Holds

The global financial markets and the local equity market have, so far, been confirming my divergence theory.

There are two implications:

One, market correlations has been continually changing. There is no fixed relationship as every political-economic variable has been fluid or in a state of flux.

This only demonstrates the apriorism of the inconstancy and complexity of the market’s behavior, which strengthens the perspective or argument that historical determinism (through charts or math models) can’t accurately predict the outcome of human actions. Even LTCM’s co-founder Myron Scholes recently admitted to such shortcomings[1].

And importantly, the activist policies by global political stewards, aimed at the non-repetition of the events that has led to the global contagion emanating from the Lehman bankruptcy episode of 2008 (which could also be seen as actions to preserve the status quo of political institutions founded on the welfare state-central banking-politically endowed banking system), have been driving this dynamic.

In short, political actions continue to dominate the marketplace[2].

Thus this transition phase has led to the distinctive performances in the relationships among market classes which can be seen across global markets.

Gold as THE Safe Haven

In today’s market distress, market leadership or the flight to safety dynamics has changed as noted last week. The US dollar which used to function as the traditional safehaven currency as in 2008 has given way to the gold backed Swiss franc and the Japanese Yen. This comes in spite of repeated interventions by their respective governments.

Another very significant change in correlations has been that of the US treasuries and gold prices.

Again, while US treasuries had been traditional shock absorber of an environment dominated by risk aversion, this time, it’s not only that gold’s correlation with US Treasuries has significantly tightened, most important is that gold has immensely outperformed US Treasuries since 2009, as shown above[3].

Gold’s assumption of the market leadership points to a vital seismic transition taking place.

Let me repeat, since gold has not been used as medium for payment and settlement, in an environment of deleveraging and liquidation, gold’s record run can’t be seen as in reaction to deflation fears but from expectations over aggressive inflationary stance by policymakers.

Arguments that point to the possible reaction of gold prices to ‘confiscatory deflation’, as in the case of the Argentine crisis of 2000, is simply unfounded; Gold priced in Argentine Pesos remained flat during the time when Argentine authorities imposed policies that confiscated private property through the banking system, but eventually flew when such policies had been relaxed and had been funded by a jump in money supply via devaluation[4].

Gold’s recent phenomenal rise has been parabolic! Gold has essentially skyrocketed by $1,050+ in less than TWO weeks! Gold prices jumped by 6% this week. The vertiginous ascent means gold prices may be susceptible to a sharp downside action (similar to Silver early this year) from profit takers.

Nonetheless gold’s relationship with other commodities has also deviated.

The correlations between gold and energy (Dow Jones UBS Energy—DJAEN) and industrial metals Dow Jones-UBS Industrial Metals—DJIAN) has turned negative, as the latter two has been on a downtrend.

However the Food or agricultural prices (represented by S&P GSCI Agricultural Index Spot Price GKX) appear to have broken out of the consolidation phase to possibly join Gold’s ascendancy.

The breakdown in correlations do not suggest of a deflationary environment but rather a ongoing distress in the monetary affairs of crisis affected nations.

The Continuing Phisix-ASEAN Divergences

The same divergence dynamics can be seen in global stock markets.

While markets in the US (SPX), Europe (STOX50) and Asia Ex-Japan (P2Dow) have been sizably down, the Philippine Phisix (as well as major ASEAN indices) appears to defy these trends or has been the least affected.

One would further note that Asian markets, despite the similar downtrends has still outperformed the US and Europe, measured in terms of having lesser degree of losses.

A broader picture of this week’s performance reveals that the ASEAN-4 has been mixed even in the face of a global equity market meltdown.

Thailand and the Philippines posted marginal gains while Malaysia was unchanged. Topnotch Indonesia suffered the most but still substantially less than the losses accounted for by major bourses.

Vietnam, which has been in a bear market, saw the largest weekly gain which may have reflected on a ‘dead cat’s bounce’, whereas Singapore endured hefty losses which also reflected on the contagion of losses from major economy bourses.

The above chart signifies as more evidence that has been reinforcing my divergence theory.

Yet growing aberrations are not only being manifested in stock markets but also in the region’s currency.

Previously, a milieu of heightened risk aversion entailed a run on regional currencies.

Today, the seeming resiliency of the ASEAN-4’s equity markets appears to also be reflected on their respective currencies.

Three weeks of global market convulsion hardly dinted on the short term uptrend of ASEAN-4 currencies seen in the chart from Yahoo Finance in pecking order Philippine peso, Indonesia rupiah, Thai baht and the Malaysian ringgit.

And when seen from the frame of the Peso-Phisix relationship, the recent selloffs share the same divergent (the actions of major economies) outlook.

The Phisix (black candle) appears to have broken down from its short term trend (light blue trend line), so as with the US-dollar Philippine Peso (green trendline) which had a breakout (breakouts marked by blue circle/ellipses) during the week.

Since I don’t subscribe to the oversimplistic nature of mechanical charting, but rather see charts as guidepost underpinned by much stronger forces of praxeology (logic of human action), we need to look at the bigger picture.

The sympathy breakdown by the Phisix, the other week, has not been supported by the broad market.

Market breadth continues to suggest that present activities have been characterized by rotational activities and consolidations rather than broad market deterioration.

Weekly advance-decline spread, which measures market sentiments has improved from last week, even if the differentials posted slight losses (left window).

Foreign buying turned slightly NET positive (right window).

One would further note that sectoral performance had been equally divided.

Services led by PLDT [PSE: TEL] along with the Holding sector, mostly from Aboitiz Equity Ventures [PSE: AEV] and SM Investments [PSE: SM] provided contributed materially to the gains of the Phisix.

The Mining industry closed the week almost at par with the performance of the local benchmark, while Financial Industrial and the property sectors fell. Again signs of rotations and consolidations at work.

These empirical evidences seem to suggest that the short term breakdown by the Phisix and the Peso may not constitute an inflection point. This will continue to hold true unless exogenous forces exert more influence than the current underlying dynamics suggests.

Money Supply Growth Plus Policy Activism Equals Low Chance of a US Recession

As I repeatedly keep emphasizing, it is unclear if such divergence dynamics could be sustained under a contagion from full blown recession or in crisis, because if it does, this would translate to decoupling.

In other words, divergence dynamics is NOT likely immune to major recessions or crisis until proven otherwise.

Yet despite many signs that appear to indicate for a sharp economic slowdown which many have said increases the recession risks in the US or the Eurozone, very important leading indicators suggest that this won’t be happening.

Importantly, the deep-seated bailout culture (Bernanke Put or Bernanke doctrine) practiced by the current crop of policymakers or the ‘activist’ stance in policymaking would likely introduce more monetary easing measures that could defer the unwinding of the imbalances built into the system.

In other words, I don’t share the view that the US will fall into a recession as many popular analysts claim.

For one, excess reserves held by the US Federal Reserves appears to have topped out (WRESBAL-lowest pane).

And this comes in the face of the recent surge in consumer lending (Total Consumer Credit Outstanding; TotalSL-highest pane). Also we are seeing signs of recovery in Industrial and Business Loans (Busloans-mid pane).

So, perhaps the US banking system could be diverting these excess reserves held at the US Federal Reserve into loans. And once this motion intensifies, this will first be read as a “boom”, which will be followed by acceleration of consumer price inflation and an eventual “bust”.

Yet it’s plain nonsense or naive to say that monetary policies have been “impotent”.

First, ZERO interest rates, which has been and will be used as the deflationary bogeyman, are exactly the selfsame excuse needed by central bankers to engage in activist policymaking (print money).

Policy ‘impotence’ would happen when inflation and interest rates are abnormally high.

Second, growing risks of recessions or crises has been the oft deployed justification to impose crisis avoidance or ‘stability’ measures. Crisis conditions gives politicians the opportunity to expand political control or what I would call the Emmanuel Rahm doctrine or creed.

The debt ceiling deal had been reached from the same fear based ‘Armaggedon’ strategy. And so has the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008[5] where the ensuing market crash from the failed first vote led to its eventual legislation.

Morgan Stanley’s Joachim Fels and Manoj Pradhan thinks that the current predicament has likewise been a policy induced slowdown.

Mr. Fels and Pradhan writes[6],

There are three main reasons for our downgrade. First, the recent incoming data, especially in the US and the euro area, have been disappointing, suggesting less momentum into 2H11 and pushing down full-year 2011 estimates. Second, recent policy errors - especially Europe's slow and insufficient response to the sovereign crisis and the drama around lifting the US debt ceiling - have weighed down on financial markets and eroded business and consumer confidence. A negative feedback loop between weak growth and soggy asset markets now appears to be in the making in Europe and the US. This should be aggravated by the prospect of fiscal tightening in the US and Europe.

While we see this as being policy induced, where I differ from the above analysts is that they see these as policy errors, I don’t.

I have been saying that since QE 2.0 has been unpopularly received, extending the same policies would need political conditions that would warrant its acceptabilty. Thus, I have been saying that current environments has been orchestrated or designed to meet such goals[7].

Fear is likely the justification for the next round of QE.

As I recently quoted an analyst[8],

But the political imperative will be to do something… anything… immediately, to ward off disaster.

Importantly, a survey of fund manageers sees a jump of expectations for QE[9].

Expectations of QE3 have doubled: 60% now see 1,100 points or below on the S&P500 Index as a trigger for QE3, up from 28% last month, and global fiscal policy is now described as restrictive for the first time since March 2009.

And we seem to be seeing more clues to the US Federal Reserve’s next asset purchasing measures.

Late last week, the US Federal Reserve has extended a $200 million loan facility via currency swap lines to the Swiss National Bank (SNB), as an unidentified European bank reportedly secured a $500 million emergency loan[10]. This essentially validates my suspicion that the so-called currency intervention by the SNB camouflaged its true purpose, i.e. the extension of liquidity to distressed banks, whose woes have been ventilated on the equity markets.

Moreover a Wall Street Journal article[11] implies that the solution (panacea) to the European banking woes should be more QEs.

Foreign banks that lack extensive U.S. branch networks have a handful of ways to bankroll U.S. operations. They can borrow dollars from money-market funds, central banks or other commercial banks. Or they can swap their home currencies, such as euros, for dollars in the foreign-exchange market. The problem is, most of those options can vanish in a crisis.

Until recently, that hasn't been a problem. Thanks partly to the Federal Reserve's so-called quantitative-easing program, huge amounts of dollars have been sloshing around the financial system, and much of it has landed at international banks, according to weekly Fed reports on bank balance sheets.

So rescuing the Euro banking system would mean a reciprocal arrangement since these banks, under normal conditions would be buying or financing the US deficits via the treasury markets. So by extending funding through the currency swap lines, the US Federal Reserve has essentially commenced a footstep into QE 3.0.

Third, suggestions that grassroots politics would impact central bank policymaking is simply groundless. The general public has insufficient knowledge on the esoteric activities of central bankers.

Henry Ford was popularly quoted that

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

That’s why the US Federal Reserve has successfuly encroached on the fiscal realm via QE 1.0 and 2.0 with little political opposition. The current political opposition has been focused on the fiscal front yet the debt ceiling bill sailed through it. Yet in case the public’s outcry for the fiscal reform does intensify, any austerity will likely be furtively channeled to central bank manueverings.

Thus, with foundering equity markets, rising credit risk environment which risks undermining the US-Euro banking system, a higher debt ceiling, and a sharp economic slowdown, the current environment seems ripe for the picking. It will be an opportunity which Bernanke is likely to seize.

The annual meeting of global central bankers at Jackson Hole, Wyomming hosted by the Kansas City Fed meeting next week could be the momentous event where US Federal Reserve Chair Ben Bernanke may unleash his second measure “another round of asset purchases” which he communicated[12] last July 13^th. This follows his first “explicit guidance” outline for a zero bound rate which had recently been made into a policy[13] (zero bound rate until mid-2013)

All these seamlessly explains the newfound gold-US treasury ‘flight to safety’ correlations.

Global financial markets addicted to money printing has been waiting for the “Bernanke Put” moment. For them, current measures have NOT been enough, and they are starving for another rescue.

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[1] See Confessions of an Econometrician August 19, 2011

[2] See Global Equity Meltdown: Political Actions to Save Global Banks, August 14,2011

[3] Gayed Michael A. Gold = Treasuries, Ritholtz.com, August 18, 2011

[4] See Confiscatory Deflation and Gold Prices, August 15, 2011

[5] Wikipedia.org First House vote, September 29 Emergency Economic Stabilization Act of 2008

[6] Fels, Joachim and Pradhan, Manoj Dangerously Close to Recession, Morgan Stanley, August 19, 2011

[7] See Global Market Crash Points to QE 3.0, August 7, 2011

[8] See The Policy Making Moral Hazard: The Bailout Mentality, August 20, 2011

[9] Finance Asia Investors slash equities, pile into cash amid growth fears, August 18, 2011

[10] See US Federal Reserve Acts on Concerns over Europe’s Funding Problems, August 19, 2011

[11] Wall Street Journal Fed Eyes European Banks, August 18, 2011

[12] See Ben Bernanke Hints at QE 3.0, July 13 2011

[13] See Global Equity Meltdown: Political Actions to Save Global Banks, August 14, 2011

Applying Emotional Intelligence to the Boom Bust Cycle

One of the myths perpetuated by those who can’t explain the behavior of markets is to resort to the “emotions” fallacy.

A good example as I pointed out is this comment[1]

Hong Kong financial official K.C. Chan urged investors to “stay calm” and not be “spooked by the market”

These people are mistaking effects as the cause. Markets don’t spook people. That’s because markets are essentially people and market price signals represents the collective actions of people. People react to markets out of certain stimulus or incentive. People don’t get euphoric or frightened for no reason.

A good example can be seen below

A fight or flight response by our brain is always result of a stimulus or incentive to act or react.

As I earlier wrote[2],

When uncertainties or the prospect of peril emerges, our brain’s amygdala responds by impelling us either to fight or to take flight. That’s because our brain has been hardwired from our ancestor’s desire for survival—they didn’t want to be the next meal for predators in the wild.

Applied to the present state of the markets, the legacy of our ancestor’s base instincts still remains with us.

So when people’s collective action results to a stock market crash, that’s because there has been an underlying uncertainty or imbalance which these participants see as having “baneful” impact to their portfolio holdings. Such stimulus or incentives triggers the amydgala’s fight or flight response even on the marketplace.

Hence if crashing markets are seen as an ephemeral episode unsupported by fundamentals then many buyers are likely to step in and put a floor to the prices. People who say that markets have been “irrational” or “emotional” are only appealing to their interventionist intuitions.

Yet if crashing markets are seen as fundamentally driven, then the crash dynamic will continue. Interventions such as the recent ban on short sales will fail[3] which 4 European nations recently applied to bank and financial issues[4].

Differentiating Short and Long Term

In addition, one cannot coherently argue that the long term outcome of markets is rational while short term outcomes are emotive (or irrational). To apply this to Warren Buffets’ celebrated commentary,

In the short run, the market is a voting machine but in the long run it is a weighing machine.

Every action by individuals contains elements of emotion. That’s because our actions are always designed to replace the current state of uneasiness. Content or discontent signify as emotional states. Emotions are simply part of individual actions. Thus seen in a collective sense, markets are always ‘emotional’ even during ‘normal’ days. Perhaps it is only in the degree where the nuances can be made.

To add, since the long run represents the cumulative effects of short run actions, there has to be a smoothing out effect for the long run actions to dominate.

Applied to Mr. Buffetts’ axiom, for the weighing machine effect to prevail over the long run, the series of short term ‘weighing machine’ dynamics has to dominate the series of short term ‘voting machine’ actions. Or the probability of distribution has to skew towards forces of the weighing machine dynamic otherwise the voting machine effect will takeover.

Boom Bust Cycles Have Real Effects

The state of the US markets appears to be revealing on such symptoms, a nice illustration can be seen in the chart below.

US markets have become nearly an “all or nothing” pattern, where market breadth reveals that stock prices in general either floats or sinks in near simultaneously during volatile days.

As Bespoke writes[5], (bold emphasis mine)

Whenever the market has a day where the net advance/decline (A/D) reading of the S&P 500 is greater than 400 or less then negative 400, we call it an 'all or nothing' day. During the credit crisis, all or nothing days were incredibly common. In 2008, we saw a peak of 52 all or nothing days, which works out to an average of about one per week. Since then, we have seen a decrease in the number of all or nothing days, but they still remain elevated.

So far this year there have been 27 all or nothing days, which works out to a still elevated annualized rate of 43. At this time just last month, there had only been 17 all or nothing days this year, which at an annualized rate of 31 would have been the lowest level since 2007. Back then, many investors were hoping that the market was finally returning to pre-crisis levels of normalcy.

As one would note from the above, current markets have hardly been about earnings, as cluster based movements represent as the NEW normal where markets have been latched to political actions more than from market forces as dogmatically embraced by mainstream.

In short, this exhibits more evidence of the increasing dependency of the S&P 500 to political interventions as a major force in influencing equity prices.

As the great Murray N. Rothbard wrote[6],

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The "boom-bust" cycle is generated by monetary intervention in the market, specifically bank credit expansion to business.

Remember, boom bust policies impacts not only the financial markets but has real impact to the economy. Through the manipulation of interest rates, patterns of consumption and savings and investment, wages, relative price levels at every stages of production, capital structure, earnings, and etc., are directed away from consumers preferences and rechanneled into stages of capital goods sector where politically directed actions would now signify as distortion of prices, miscoordination of resources or as malinvestments which eventually would have to be liquidated.

Again Mr Rothbard,

If this were the effect of a genuine fall in time preferences and an increase in saving, all would be well and good, and the new lengthened structure of production could be indefinitely sustained. But this shift is the product of bank credit expansion. Soon the new money percolates downward from the business borrowers to the factors of production: in wages, rents, interest. Now, unless time preferences have changed, and there is no reason to think that they have, people will rush to spend the higher incomes in the old consumption-investment proportions. In short, people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.

Today’s market environment has accounted for as the continuing saga of the 2008 liquidation phase which has been constantly delayed, deferred and partly absorbed by government through sundry interventions and systemic inflationism designed to save the fragile, broken and unsustainable system.

And the effects of the gamut of political interventionism has been manifesting into the actions of equity markets.

Everybody can wish for the old days, but prudent investors would need to face up with reality or take the consequences of ideological folly.

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[1] See Japan's Minister Calls for More Inflationism to Stem Global Market Crash, August 19, 2011

[2] See Managing Risk and Uncertainty With Emotional Intelligence, March 20, 2011

[3] Bespoke Invest, A Rough Week For European Banks, August 19, 2011

[4] See War against Short Selling: France, Spain, Italy, Belgium Ban Short Sales August 12, 2011

[5] Bespoke Invest, 'All or Nothing' Days on the Rise, August 16, 2011

[6] Rothbard, Murray N. The Positive Theory of the Cycle, Chapter 1 America’s Great Depression

The Zombie Political Economy

The welfare state breeds and fosters violence.

Daily Reckoning’s Bill Bonner explains, (bold emphasis mine)

In economic terms, a zombie is a parasite. He contributes less to the economy than he takes from it. He lives at the expense of others.

Almost any profession or career can be a nest for a zombie; an auto mechanic who rips off his customers, for example, is a zombie…at least in a sense. But most often, zombies are created, enabled, and supported by government. Government transfer payments create whole armies of zombies. Government bailouts turn whole industries into zombies. Government programs and government employment turn millions of otherwise reasonably honest and reasonably productive people into leeches. A guy who might have been a decent gardener, for example, becomes an SEC lawyer or a Homeland Security guard.

Politicians like zombies. Zombies are cheap. If you buy a vote from a man who is independently wealthy, it’s gonna cost you. And the bourgeoisie – which earns its money from honest toil and enterprise – is hard to buy. But zombie votes? They’re a dime a dozen. Just increase Social Security or Medicare; the zombies will line up to vote for you.

It’s relatively easy to turn people into zombies. And it’s fairly easy to support them when an economy is healthy and expanding. But when an economy goes into a contraction, you can no longer afford to give the zombies their meat. Then what?

Then, watch out. The zombies rise up.

Let me add that political economic parasitism has inherent limits, not only from the state of the economy, but most importantly, from the availability of supply of hosts.

Once parasites have grown extensively out of the proportion to the supply of hosts, the system collapses.

Political dependency, then, mutates into violence.

The Policy Making Moral Hazard: The Bailout Mentality

To give you an example how the ‘Bernanke Put’ or the ‘Bernanke doctrine’ has worked to ingrain the psychology of moral hazard to the Financial industry, here is an example where Panic is seen as a buy, principally because of the political ‘need to do something’.

In short, the bailout mentality.

From analyst Martin Spring (bold emphasis mine)

If there is another major crisis – perhaps deadlock in Europe as voters in the North torpedo plans to implement a fiscal union and prevent issuance of bonds for the Eurozone as a whole, underpinned by the power of the German economy – or even just a general worsening in the global economy, with employment and/or property crisis in the US, then it’s very likely that that will panic policymakers.

-Central banks will go crazy with “printing” and otherwise unorthodox money-pumping policies;

-Despite growing public resistance to rising federal debt in America, and to “rescue” packages in Europe, governments will find ways to spend more to stimulate demand;

-In Asia, where sounder fundamentals allow policymakers more freedom of action, there could be a switch from fighting inflation to promoting domestic demand.

Of course, such changes could build up even greater problems for the future, such as the eventual threat of serious inflation facilitated by the money bubble. But the political imperative will be to do something… anything… immediately, to ward off disaster.

The equity markets will love such a panicky turnaround. The next couple of months at least … maybe longer… will be the time to use most of the cash that you should have realized and parked awaiting such an opportunity, to invest in shares.

Mr. Spring is right, a realization of this short term political patchwork would essentially translate to crisis begetting more crisis.

Nevertheless, political actions are almost always focused on short term (palliative) effects and directed at attempts to resolve problems of politically 'favored' sectors.

Japan's Minister Calls for More Inflationism to Stem Global Market Crash

Here we go again. Crashing markets has prompted policymakers to make “assurances” to the public.

From Bloomberg, (bold emphasis mine)

The G-7 needs “very close cooperation in coming weeks,” Japanese Finance Minister Yoshihiko Noda said in Tokyo, where the Topix index fell to a two-year low. Hong Kong financial official K.C. Chan urged investors to “stay calm” and not be “spooked by the market,” as the Hang Seng index slumped 2.4 percent. In Beijing, Vice President Xi Jinping said his nation will avoid an economic hard landing.

Plunging equity markets are crushing consumer and business confidence, worsening the outlook for a global economy already hampered by the debt burdens of developed nations. Speculation that European banks may have insufficient capital and signs of weakness in the U.S. economy are helping to drive a stock rout that returned to Asia today…

It’s sad to see how logic works for politicians. Investors don’t get spooked by the markets. Instead, investors sell the markets down for certain reasons, particularly the unresolved problems or uncertainty from the continuing debt crisis that plagues the Eurozone and the US. Such frenetic selling has been vented on the markets. The effects are not the cause.

So what steps will they assure investors?

Again from the same article, (bold emphasis mine)

Asked how policy makers should respond to market turmoil, Noda referred reporters to an Aug. 8 pledge by G-7 finance ministers and central bank governors to “take all necessary measures to support financial stability and growth.” He didn’t specify any likely next step.

A past example of joint action is the intervention that temporarily weakened Japan’s currency after the nation’s March earthquake. Major developed nations are hampered in further stimulating their economies because of their debt burdens, and have limited or no room for interest-rate cuts after reductions that countered the financial crisis of 2008.

Their proclivity is to implement the very same set of actions that has created this problem in the first place, where more inflationism translates to greater volatility via the boom bust cycles.

It isn’t that governments don’t learn, rather governments prefer to adapt actions that have short term beneficial effects but with long term untoward costs. It’s a vicious cycle.

Video: Steve Horwitz on the Real Cost of Living

Increasing productivity (measured in labor time spent to buy specific goods or services) and widespread technological innovation which has brought about extensive consumer surpluses (non-monetary utility benefits) has brought about better quality of living over 100 years, in spite of the myriad interventions by the government.

Confessions of an Econometrician

From FIN Alternatives (bold emphasis added)

A co-founder of Long-Term Capital Management said that the legendary collapsed hedge fund’s leverage ensured its fate.

LTCM collapsed in 1998—a year after Myron Scholes won the Nobel Prize in economics—forcing the Federal Reserve to arrange a bailout. At the time, it was the largest-ever hedge fund failure.

Scholes, who went on to found hedge fund Platinum Grove Asset Management, now says that the firm’s leverage doomed it in the wake of Russia’s sovereign debt default.

“LTCM ran leveraged positions at too-high risk levels,” Scholes told Risk. “It was not a sustainable business in the longer run if you have to reduce leverage and seek extra capital at a time when risk transfer costs are high.”

And this risks inherent in LTCM’s portfolio were higher than anyone realized at the time.

“It was a much higher-probability event than people thought, because it told people they were going to make 40% a year at 20% volatility—a high risk level,” Scholes said of LTCM’s demise. “The problem comes because, as a hedge fund, you don’t really have deep pockets, so it’s hard to run at a high risk for a long time.”

Scholes also blamed an over-reliance on classic portfolio theory.

“Capital models should give levels that are required to sustain the business at times of shock, and this is different for leveraged hedge funds because they can’t call for additional capital from investors,” he told Risk. “I believe capital models should not rely on portfolio theory, because the correlation structure is just not constant—in a crisis, you have intermediaries reducing risk simultaneously, so things that appeared to be independent clusters in the past become correlated, and diversification against those clusters does not provide staying power.”

In short, taking too much risk via leverage based on the assumption of the infallibility of econometric models.

As the great Ludwig von Mises warned (bold emphasis mine)

But it is not permissible to argue in an analogous way with regard to the quantities we observe in the field of human action. These quantities are manifestly variable. Changes occurring in them plainly affect the result of our actions. Every quantity that we can observe is a historical event, a fact which cannot be fully described without specifying the time and geographical point.

The econometrician is unable to disprove this fact, which cuts the ground from under his reasoning. He cannot help admitting that there are no "behavior constants."

US Federal Reserve Acts on Concerns over Europe’s Funding Problems

The whack a mole strategy being applied by officials of crisis stricken doesn’t seem to work.

Now the US officials are getting increasingly concerned over the escalating banking problems at the Eurozone.

Reports the Wall Street Journal (bold highlights mine)

Federal and state regulators, signaling their growing worry that Europe's debt crisis could spill into the U.S. banking system, are intensifying their scrutiny of the U.S. arms of Europe's biggest banks, according to people familiar with the matter.

The Federal Reserve Bank of New York, which oversees the U.S. operations of many large European banks, recently has been holding extensive meetings with the lenders to gauge their vulnerability to escalating financial pressures. The Fed is demanding more information from the banks about whether they have reliable access to the funds needed to operate on a day-to-day basis in the U.S. and, in some cases, pushing the banks to overhaul their U.S. structures, the people familiar with the matter say.

Officials at the New York Fed "are very concerned" about European banks facing funding difficulties in the U.S., said a senior executive at a major European bank who has participated in the talks…

Regulators are trying to guard against the possibility European banks that encounter trouble could siphon funds out of their U.S. arms, these people said. Regulators recently have ramped up pressure on European banks to transform their U.S. businesses into self-financed organizations that are better insulated from problems with their parent companies, a senior bank executive said.

In one sign of how European banks may be having trouble getting dollar funding, an unidentified European bank on Wednesday borrowed $500 million in one-week debt from the European Central Bank, according to ECB data. The bank paid a higher cost than what other banks would pay to borrow dollars from fellow lenders. It was the first time for that type of borrowing since Feb 23.

Anxiety about European banks' U.S. funding comes amid broader concerns about whether Europe's struggling banks will be able to refinance maturing debt in coming years. Investors, wary of many European banks' holdings of debt issued by troubled euro-zone governments, are shunning large swaths of the sector. While top European banks already have satisfied about 90% of their funding needs for 2011, they still need to raise a total of roughly €80 billion ($115 billion) by the end of the year, according to Morgan Stanley.

Part of the $500 million loan was said to have been funded by the US Federal Reserve via $200 million currency swap lines to the Swiss National Bank (!), according to Zero Hedge. There goes another stealth QE.

This partly validates my earlier suspicion that SNB’s intervention in the currency markets has been mostly about providing liquidity to the distressed equity markets which has been symptomatic of the banking sector’s woes.

I would suspect that part of this intervention, aside from publicly wishing for a weaker franc, is to flood the system with money to mitigate the losses being endured by European equity markets.

Nonetheless the wild swings in global markets seem to suggest that the recent measures undertaken by the US Federal Reserve or the ECB have been deemed as ‘inadequate’.

Remember, since 2003, global financial markets have increasingly been dependent on central bank policies, where the 2008 crisis has made financial markets essentially stand on the crutches of the Fed’s money printing policies. In short, global equity markets have been mostly dependent on the combination of QEs and an extended low interest rate environment.

And as stated earlier, given Europe’s funding problems which may spillover to the US, it is very likely to expect that the US Federal Reserve will eventually conform to the desires of markets addicted to central bank steroids with aggressive dosages.

And this is being signaled by record gold prices.

Record Gold Prices and Bond Spreads Point to Stagflation

Amidst last night’s second chapter of this year’s global stock market rout, GOLD prices has spiked anew to record highs breaking above the $1,800 level (or added $1,000 in just 10 days!!!).

I have been repeatedly (nauseously) saying here that gold’s rise has been in the account of greatly increased expectations of more inflationary actions by the central bankers.

The US bond markets appear to be echoing gold’s actions.

This from Bloomberg’s Chart of the Day, (bold emphasis mine)

The Federal Reserve’s unprecedented pledge to hold interest rates at a record low risks creating an inflationary surge once the economy starts to accelerate, Treasury bond trading shows.

The CHART OF THE DAY tracks the difference between yields on the 30-year Treasury bond and its Treasury Inflation Protected Securities counterpart and the same comparison for two-year notes. The lower panel shows that the gap between those so-called breakeven rates reached the widest since December this week, as the Fed’s commitment to hold down borrowing costs, announced after an Aug. 9 meeting, intensified concern inflation would accelerate.

“Because the Fed maintained fund rates at exceptionally low levels, that’s causing inflationary expectations to pick up,” said Hiroki Shimazu, senior market economist in Tokyo at SMBC Nikko Securities Inc. “In the long-term, there are much bigger problems for the U.S. economy. This is one of the warning signs.”

The spread between yields on two-year notes and so-called TIPS, which gauges trader expectations for consumer prices over the life of the debt, narrowed to 0.95 percentage point on Aug. 16. When using 30-year bonds and same-maturity TIPS, the figure jumps to 2.61 percentage points. The difference between the measures was 1.66 percentage points, the highest this year.

The establishment's commentary misleads the public when they attribute the cause and effect relationship of inflation to economic growth.

The fact is inflation arises from money printing or expansion of fiduciary media, and can accelerate even when the economy is in the doldrums such as in the stagflation era of the 70s (shown below- US consumer prices on a year annual % change trended up even during 3 recessions).

Or for a more extreme example, Zimbabwe’s hyperinflation episode which came amidst an economic depression (falling GDP, very high unemployment)

Bottom line: Gold and current bond spreads currently point to risks of stagflation

China Takes Steps to Relax Currency Controls

Amidst the political demand for higher taxes, more government spending, bailouts and centralization schemes by the US and Europe, China seems going on the opposite way and appears to be making a step in the right direction: by relaxing currency controls

From Bloomberg,

Chinese Vice Premier Li Keqiang unveiled the biggest package of measures supporting Hong Kong’s economy since the 2003 SARS epidemic, allowing more two-way investment in shares and sparking a rally in brokerage stocks.

China will start an exchange-traded fund based on Hong Kong equities, Li, the front-runner to replace Wen Jiabao as premier in 2013, said at a forum in the city today. He also pledged a 20 billion yuan ($3.1 billion) quota for qualified companies to invest in domestic Chinese securities and said sales of yuan bonds in the city will be expanded.

The plans relax restrictions on investment flows, bolstering the city’s role as a financial hub and aiding an economy that shrank in the second quarter for the first time since 2009…

Making the announcements in person, with the heads of the central bank and commerce ministry, was “a symbolic demonstration of Beijing’s commitment to Hong Kong,” said Kwok. The quota for qualified foreign institutional investors is a yuan-settled version of an existing program settled in dollars, she said.

China will expand its companies’ offshore bond sales and support the use of yuan for foreign direct investment in the nation, Li said. The city’s status as a financial center “is crucial for Hong Kong’s development,” he said.

I hope to see more of this not only for China but for the rest of Asia, including the Philippines.

Quote of the Day: Gold Standard from the Fringes to the Mainstream

The gold standard once thought as a ‘barbaric relic’, is like the proverbial phoenix rising from the ashes.

When the gold standard has been mentioned as “no longer unthinkable” by the lefty New York Times, we understand that the public's outlook of gold as money has moved from the fringes into the mainstream.

Today’s quote from Martin Hutchinson and John Foley (hat tip Jeffrey Tucker Mises Blog- yes vindication for Henry Hazlitt)

But further chipping at the dollar’s credibility, further downgrades of United States credit or other harmful results from years of very low interest rates could bring more people around to the idea of a new reserve currency. A return to the gold standard remains unlikely, but it’s no longer unthinkable.

Prices signals have been working their way to affect the public’s psychology where…

…Denial, apparently, has been transitioning into acceptance.

It seems like the psychological Kubler Ross Grief cycle process at work here. The higher gold prices are, the more the public will embrace the thought of the return of the gold standard.

How Tax Policies Affect Investments

From Steven M. Davidoff at the New York Times (bold emphasis mine)

Apple has a cash problem. It’s not just that Apple has too much cash, $76 billion as of June 30. It’s rather that the bulk of that pile, estimated at $41 billion, is held abroad.

Apple does not want to bring it back to the United States for several reasons, primarily because of the tax consequences, but also because of its own growing foreign presence. Apple is not alone — this problem is an increasing one in corporate America. And the answer may not be more big, all-cash acquisitions, like Google’s $12.5 billion offer for Motorola Mobility.

In an analyst report in May, JPMorgan Chase estimated that 519 American multinational corporations had $1.375 trillion outside the United States. The problem is particularly acute among technology companies, which historically tend to hoard cash because of the cyclical nature of their business.

A recent Moody’s report noted that Microsoft held $42 billion abroad, or more than 80 percent of its cash. Cisco Systems has $38.8 billion, or almost 90 percent of its cash. Google — at least before Monday’s deal — had nearly $40 billion in cash, with more than 43 percent of it held abroad

Tax policy is driving much of this trend. For multinational corporations, cash earned abroad cannot easily be remitted to the United States. If it is paid back to the United States, it is subject to a dividend tax that can rise to as much as 35 percent. Companies are loath to pay this tax because while they can offset it with taxes paid abroad, the companies still end up paying a relatively high tax rate.

Again, tax policies are seen as one of the major forces in prompting for distortions of investment decisions. This greatly affects the allocations of resources or the economy.

In the case above, money which should have been used for more investments or for paying off shareholders in the US has been hoarded overseas.

On the other hand, globalization is an issue too. (bold emphasis mine)

Yet it is not just a tax issue. Many United States companies want to keep cash abroad to focus on high-growth regions for investments and acquisitions.

A recent Standard & Poor’s study found that 50 percent of sales by companies in the S.&P. 500-stock index are outside the United States. Interestingly, the report also found that these companies paid more in foreign taxes than to the United States government. For Apple, 60 percent of its sales are abroad, and like these other companies, its foreign sales are expected to only go higher.

So, for those who expect that a change in tax policy would prompt Apple and other companies to put their cash piles to use in the United States, don’t be so sure. Even if there were no dividend tax, a large portion of this cash would stay abroad as these companies focus on higher growth overseas for investment.

Of course there many other domestic factors involved too which contributes to investment or resource allocation dynamics, this comes in the substance of monetary policies, regulatory climate, growing heft of political distribution of resources (seen via deficits) and etc.

The above evinces that world is complex, with variable interloping factors at work and simply can’t be ‘modeled’.

Point is: political actions affect the economy, most of them negative.

As a caveat, this not only applies to the US but everywhere including the Philippines. Thus, we have to be vigilant with politicos calling for more regulations or taxes or other interventionist measures.

Archeological Findings: The Origin of the State: War

Sociologist Franz Oppenheimer theorized that the state was born out of war.

From Mr. Oppenheimer

The State, completely in its genesis, essentially and almost completely during the first stages of its existence, is a social institution, forced by a victorious group of men on a defeated group, with the sole purpose of regulating the dominion of the victorious group over the vanquished, and securing itself against revolt from within and attacks from abroad. Teleologically, this dominion had no other purpose than the economic exploitation of the vanquished by the victors."

No primitive state known to history originated in any other manner. [1] Wherever a reliable tradition reports otherwise, either it concerns the amalgamation of two fully developed primitive states into one body of more complete organisation, or else it is an adaptation to men of the fable of the sheep which made a bear their king in order to be protected against the wolf. But even in this latter case, the form and content of the State became precisely the same as in those states where nothing intervened, and which became immediately 'wolf states'." (p. 15)

Recently some archeologists have found evidence in support of Mr. Oppenheimer’s theory.

From the New York Times, (bold emphasis mine) [hat tip Charles Burris]

Some archaeologists have painted primitive societies as relatively peaceful, implying that war is a reprehensible modern deviation. Others have seen war as the midwife of the first states that arose as human population increased and more complex social structures emerged to coordinate activities.

A wave of new research is supporting this second view. Charles Stanish and Abigail Levine, archaeologists at the University of California, Los Angeles, have traced the rise of the pristine states that preceded the Inca empire. The first villages in the region were formed some 3,500 years ago. Over the next 1,000 years, some developed into larger regional centers, spaced about 12 to 15 miles apart. Then, starting around 500 B.C., signs of warfare emerged in the form of trophy heads and depictions of warriors, the two archaeologists report in last week’s Proceedings of the National Academy of Sciences…

Dr. Stanish believes that warfare was the midwife of the first states that arose in many regions of the world, including Mesopotamia and China as well as the Americas.

The first states, in his view, were not passive affairs driven by forces beyond human control, like climate and geography, as some historians have supposed. Rather, they were shaped by human choice as people sought new forms of cooperation and new institutions for the more complex societies that were developing. Trade was one of these cooperative institutions for consolidating larger-scale groups; warfare was the other.

Warfare may not usually be thought of as a form of cooperation, but organized hostilities between chiefdoms require that within each chiefdom people subordinate their individual self-interest to that of the group.

“Warfare is ultimately not a denial of the human capacity for social cooperation, but merely the most destructive expression of it,” the anthropologist Lawrence H. Keeley writes in his book “War Before Civilization” (Oxford, 1996).

The primary innate instinct of every state is to establish and preserve political control through violence.