Public Choice Theory Applied to the Political Economy of US Ethanol

A great example of the public choice theory in action

Writes Randall Holcombe at the Mises Blog (bold mine)

This article notes that in 2000 about 5% of the corn crop went to the production of ethanol, and by 2013, 40% of the corn crop was devoted to ethanol production. The increased demand for corn resulted in a doubling of the per bushel price of corn.

The U.S. Department of Agriculture says in 2011 the total value of the corn crop was $63.9 billion, and that there were 400,000 corn farms in the United States. Because the price of corn has doubled due to the mandate, half of that revenue, or $31.95 billion, is a transfer from consumers to corn farmers in the form of higher prices.

Dividing that $31.95 billion cost among 319 million Americans, the cost to each American from the ethanol mandate is just about $100 a year. That includes not only the price of ethanol, but the higher price of corn in all its other uses.

That $31.95 billion is shared among the 400,000 corn farmers, so the average benefit to each farmer is $79,875.

This is a good example of how legislation providing concentrated benefits to an interest group and imposing disbursed costs on everybody can maintain political support. There is much less incentive to for individuals to mount political opposition against a program that costs them $100 a year than there is for individuals to support a program that nets them $79,875 a year.

As Housing Prices Crash at Record Speed, Chinese Government Bails Out Developer, Injects Liquidity

And the Chinese government declared that they would supposedly conduct reforms. But the reforms they have currently embarked on has been to save the status quo.

The Chinese government just rescued a major property developer.

From the New York Times:

Chinese banks have extended $16 billion in credit lines to shore up one of the country’s largest and most heavily indebted home builders, as pressure mounts on developers short of cash in a slumping property market.

The move by a group of mainly state-run banks to bolster the builder, Evergrande Real Estate Group, which is controlled by the billionaire Hui Ka Yan, is the latest sign of tumult in China’s sprawling housing sector.

Developers are rushing to secure financial support as sales volumes and housing prices plunge, weighed down by a growing overhang of unsold homes. The Kaisa Group, once a favorite of foreign investors, nearly defaulted on its offshore debt this year before being rescued by another developer.

Evergrande said on Tuesday that since February, it had secured new credit lines totaling 100 billion renminbi, or $16.2 billion. Those included a new 30 billion renminbi commitment on Monday from the Bank of China, which regards the developer as “its most important bankwide long-term partner,” Evergrande said in a news release.

The current measures has been meant as band-aid to a hemorrhage...

Analysts said the support from the banks — which also include the Agricultural Bank of China, Postal Savings Bank of China and the privately controlled China Minsheng Bank — would provide temporary relief but would fall short of addressing the company’s deeper problems.

Mounting debts and slumping sales “are fundamental challenges that can’t be resolved short term by government’s bailing them out on ‘too big to fail’ pretense,” said Junheng Li, the head of research at JL Warren Capital in New York.

“The company has been under financial distress for a long time,” she added.

Whether it is short term or not, resources redistributed to non-productive activities would worsen the current conditions going forward.

 

And this comes as the crash in Chinese home prices has even been intensifying.

From Investing.com (bold mine)

Property prices fell again in most major Chinese cities in February, amid continuing anxiety about the state of the country’s real estate sector. New house prices declined in 66 of 70 large- and medium-sized cities surveyed, according to China’s National Bureau of Statistics (NBS). Prices fell an average of 0.4 percent on the previous month, ending 5.7 percent lower than a year earlier, according to Reuters. It is the biggest year-on-year fall since the national survey began in 2011.

The only major cities that did not see a drop were the southern special economic zone of Shenzhen, where prices rose 0.2 percent, and the central industrial city of Wuhan, which saw no change. Prices for the secondary market also fell in 61 cities, though there were rises in five cities. The bureau blamed the sharp fall partly on February’s week-long Chinese New Year vacation, and predicted that prices would rebound this month. That did not stop the figures attracting widespread attention, however: one Chinese-language news website blared the headline: “Hangzhou house prices back to their level of five years ago?”

From CNBC (bold mine)

China new home prices registered their sixth straight month of annual decline in February, as tepid demand continued to weigh on sentiment despite the government's efforts to spur buying. 

New home prices fell 5.7 percent on year in February, according to Reuters calculations based on fresh data from the National Bureau of Statistics on Wednesday. The reading was worse than January's 5.1 percent decline and marks the largest drop since the current data series began in 2011.

Meanwhile, both Beijing and Shanghai clocked home price declines. In Beijing, prices fell 3.6 percent on year following a 3.2 percent drop in January, while prices in Shanghai fell 4.7 percent, following January's 4.2 percent drop.

So pressures from housing problems has filtered into the credit system, thereby manifesting strains in the repo markets.

The government’s response? Well, to inject money.

From Bloomberg: (bold mine)

China’s interest-rate swaps dropped the most in six weeks after the central bank took extra steps to boost liquidity to cushion an economy grappling with capital outflows and slowing growth.

The People’s Bank of China said it auctioned seven-day reverse-repurchase agreements at 3.65 percent, down from 3.75 percent last week. The central bank also rolled over 350 billion yuan ($73 billion) of loans it extended to banks via its medium-term lending facility in December, according to a person with knowledge of the matter, who asked not to be identified because the information hasn’t been made public. An unknown amount of lending was also added, the person said.

So reforms have actually been about the preserving the status quo.

The Chinese government reported that credit in February unexpectedly ballooned

From Bloomberg (bold mine)

Aggregate financing was 1.35 trillion yuan ($215.5 billion) in February, the People’s Bank of China said in Beijing Thursday, above economists’ median estimate of 1 trillion yuan. New yuan loans totaled 1.02 trillion yuan and M2 money supply rose 12.5 percent from a year earlier. 

With two interest-rate cuts and one reduction to the percentage of reserves banks have to set aside in the past four months, the central bank is seeking to cushion China’s slowdown. Industrial output, investment and retail sales growth missed analysts’ estimates in January and February, suggesting more stimulus is needed to boost the world’s second-largest economy.

“We see continued pretty solid core bank lending but a further slowdown in shadow banking,” said Louis Kuijs, Royal Bank of Scotland Group Plc’s chief Greater China economist in Hong Kong. “Authorities are trying to push liquidity into the system, but in terms of real economic entities, demand for credit is not very strong.”

But obviously the sponges for those credit expansion have likely been via State Owned Enterprises or politically controlled private institutions. 

As for the real economy, the disparity between credit expansion in the light of “demand for credit is not very strong”, crashing housing prices, and stagnating real economy implies that the Chinese economy has been plagued by substantial balance sheet impairments. You can lead the horse to the water but you cannot make him drink. 

However Chinese stocks continue to deviate from reality with its sustained upside move.

Of course it could most likely be that part of the credit expansion being foisted by the government to the system has been finding their way to chase yields via stocks.

So reforms has been about blowing one bubble after another. All temporary measures intended to kick the can down the road.

And naturally, because credit infused into the system will spillover to some areas of the real economy, there will be an outlet for this.  A clue to this has been that aside from retail punters, the shadow banking system have most likely been another major driver of the Chinese stock market mania.

From Reuters: (bold mine)

China's trust firms, with total assets of $2.2 trillion, are shifting more cash into frothy capital markets and over-the-counter (OTC) instruments instead of loans - blunting regulators' efforts to reduce shadow banking risk.

By redirecting money into capital markets and OTC products like asset-backed securities (ABS) and bankers' acceptances, trusts are acting less like lenders and more like hedge funds or lightly regulated mutual funds.

And the shift - a response to a clampdown last year on trust lending to risky real estate and industrial projects - means a significant chunk of shadow banking risk is migrating rather than shrinking…

Previously, people who bought into opaque wealth management products, many of which were peddled by banks but actually backed by trust assets, found themselves heavily exposed to real estate loans. Trust firms' changing asset mix means these investors may now instead find themselves exposed to high-yield corporate debt (junk bonds), volatile stock funds or risky short-term OTC debt instruments.

Oh, as for the pace at which housing prices have been crashing, they appear to be shortening the path to a Chinese recession/crisis. 

So there should be more defaults ahead.  Yet can the Chinese government fill in every defaulter's shoe? If not, market developments are likely to even deteriorate further.

As I previously noted:

Should the US housing bubble bust experience serve as a model, then a sustained housing deflation in China means that the latter's economy may fall into recession by mid 2016. 

But if the rate of the unwinding of the Chinese housing bubble accelerates, then this may shorten the time window. 

However, the Chinese government has been preemptively easing. The Chinese government has been joined by many other global central banks who appears to have also been frantically easing. 

Will such joint actions help extend or delay the process? Hmmmm.

It’s a complex world with manifold factors. But the writing is clearly on the wall.

Record stocks in the face of record imbalances at the precipice.

And once a recession/crisis has surfaced expect volatility in Chinese politics.

So what will the Chinese government do aside from reforms that has actually meant preserve the status quo?

Beat the drums of war to divert public attention from economic travails and to shore up domestic political capital, perhaps?

Statistical Inflation Diverges from Reality: In UK, e-Cigarettes and Craft Beers have been included

Governments arbitrarily conjure up statistical numbers to show what they want to show…

So e-cigarettes, craft beers, streaming music among other items have been included in the UK’s government statistical measure of inflation.

From the BBC (bold mine)

E-cigarettes and specialist "craft" beers have been added to the basket of goods used to measure the UK's inflation rate.

The additions are part of the Office for National Statistics' (ONS) annual revision of the basket.

The cost of music streaming services has been added as well, but sat-navs have been dropped.

The basket of goods currently contains 703 items and services, of which 13 are new this year after eight were removed.

The inflation rate currently stands at a record low of 0.3%, as measured by the Consumer Prices Index.

Price survey

The ONS said that e-cigarettes had been added because many smokers were using them.

Sales of "craft" beers have been brought in because more money is being spent on them, along with a rise in the shelf space devoted to those beers in shops and supermarkets.

Although only around 700 items have their prices tracked each month, many are measured in several places. So 110,000 prices are collected from 20,000 shops in the UK, with another 70,000 prices measured online.

Revisions to this year's basket continue to reflect the fast-moving change in the use of technology.

For 2015, the cost of music streaming services has been included, along with subscriptions to online console computer games.

Headphones have been added too, as well as mobile phone accessories such as covers and chargers.

So the average UK residents have now been shown as being smokers and craft beer drinkers, yet pity the non-smokers and non craft beer drinkers.

Yet how “many” is “many” as to merit the inclusion of e-cigarettes in the basket? Even among craft beer drinkers, not everyone spends the same. Some spend more than the others. What if the monied class have been spending more on craft beers for retail outlets to devote shelf space on them? If this supposition holds true then this skews the weighting of the inflation basket to the expenditures by the monied class. Or said differently, the CPI basket may reflect more on expenditures by the elite than by the average.

The point of the above hasn’t been about e-cigarettes or craft beer drinkers but about how statistics accurately reflect on the individual’s spending patterns.

This differentiates between statistics—aggregation of numbers based on arbitrary parameters set by political agents—and economics—how resources are allocated subjectively by individuals.

US Dollar Standard In Jeopardy: Australia, Germany, France and Italy to Join China’s Infrastructure and Investment Bank

I have recently blogged  about out how the US government has been losing political capital. In the context of geopolitics, UK has decided to join China’s $50bn Asian Infrastructure Investment Bank, the first among the G-7 nations despite American protests.

But bad news appear to be mounting for the US as many other nations appear to be jumping aboard China’s project.

First, Australia warms up to the Chinese  project.

From the Australian Financial Review:

The Australian Industry Group has urged the federal government to push ahead with joining China's specialist infrastructure bank declaring this would make the country an active participant in the changing economic landscape of the region rather than just a bystander.

The business group's chief executive Innes Willox welcomed signs the government was changing its mind on the institution saying this would position Australia as a player in strategic decision making in regional infrastructure investment and further its regional trade activities.

Treasurer Joe Hockey signalled last Friday that Australia was reconsidering its opposition to the US$50 billion Asian Infrastructure Investment Bank (AIIB) after decisions by New Zealand and the United Kingdom to join.

Today Germany, France and Italy reportedly announced plans to also hop into the Chinese bandwagon

From the Guardian:

Gap widens between US and allies on new China-led lending body, with Britain among other countries already taking part in AIIB and Australia considering it

A senior US diplomat said it was up to individual countries to decide on joining a new China-led lending body, as media reports said France, Germany and Italy have agreed to follow Britain’s lead and join the Asian Infrastructure Investment Bank (AIIB).

A growing number of close allies were ignoring Washington’s pressure to stay out of the institution, the Financial Times reported, in a setback for US foreign policy.

In China the state-owned Xinhua news agency said South Korea, Switzerland and Luxembourg were also considering joining.

The Financial Times, quoting European officials, said the decision by the four countries to become members of the AIIB was a blow for Washington, which has questioned if the new bank will have high standards of governance and environmental and social safeguards.

The US dollar standard looks very much in jeopardy

Charts of the Day: The Uber Effect: New York Taxi Bubble Deflates

Both charts from AEI’s Mark Perry

Austrian economist Thomas DiLorenzo on Uber via the Lew Rockwell Blog:

New York City’s taxicab monopoly “kingpin” can’t pay his debts, thanks to competition from lower-priced/higher quality Uber drivers.  Citibank is foreclosing on 90 of his monopoly “medallion” loans.  Go, Uber Go!

New York’s decades-old taxicab “medallion” crony-capitalist scheme was set up to limit competition in the business, thereby creating monopoly profits for then-existing cab companies.  It’s the urban version of mercantilist agricultural policies that pay farmers for NOT growing crops or raising livestock.  The current price of one of these medallions is around $800,000, down from over $1 million in June of last year thanks to competition from Uber.  Let’s hope that every last one of these “kingpins” is driven from the market by Uber (and other free-market competitors).

Bubbles have always been a product of government interventions.

Wow, Philippine Remittance January Growth Rates Collapse to Near Zero or Post 2009 Crisis Levels!

Here is the Bangko Sentral ng Pilipinas BSP’s sanitized remittance report for January 2015

 

See BSP’s table here, a longer version of the table can be acquired from the BSP's statistics page

First personal remittances…(bold mine)

Personal remittances from overseas Filipinos (OFs) in January 2015 amounted to US$2.0 billion, higher by 0.2 percent than the year-ago level, Bangko Sentral ng Pilipinas Governor Amando M. Tetangco, Jr. announced today.  Personal remittances from land-based workers with work contracts of one year or more registered inflows of US$1.5 billion. Meanwhile those from sea-based and land-based workers with work contracts of less than one year totaled US$0.5 billion.

A picture speaks a thousand words.

Here is what the BSP didn’t say or refused to say…

Next cash remittances…

Cash remittances from OFs coursed through banks reached US$1.8 billion in January, representing a 0.5 percent year-on-year growth. Cash remittances from land-based and sea-based workers posted inflows of US$1.4 billion and US$0.5 billion, respectively.  The bulk of cash remittances came from the United States, Saudi Arabia, the United Arab Emirates, the United Kingdom, Japan, Singapore, Hong Kong, and Canada.

Again here is what the BSP didn’t say or avoided from saying…

January's remittance growth rates has crashed to almost January 2009 levels (.1% growth for both personal and cash remittances)! To recall, 2009 was the aftermath of the 2008 Great Financial Crisis!  

 

Yet this doesn’t seem to be an anomaly, remittance growth trend has been showing some strains even prior to the November 2014 meltdown where monthly personal remittances growth rates sunk to 1.8% while cash remittances growth rates tanked to 1.5% (adjusted) from the 5.5% to 8% range, as I pointed out here. 

The January trend seems to have only reinforced the current dynamic. Yet if the current momentum persists, then remittance growth rates might turn negative or contract over the coming months. Wow!

I have warned that collapsing oil prices would likely impact remittances last December.

And yet how will the blowing up of the Middle East bubble extrapolate to Philippine OFW remittances? More than half or about 56% of OFWs according to the Philippine Overseas Employment Administration (POEA) have been deployed to this region. Will OFWs (and their employers) be immune from an economic or financial crisis? This isn’t 2008 where the epicenter of the crisis was in the US, hence remittances had been spared from retrenchment. For this crisis, there will be multiple hotbeds. The ongoing crashes in oil-commodity spectrum have already been showing the way.

Again it’s a writing on the wall for the public hype called “consumer driven” economic boom.

This partly explains the ongoing pressures in retail activities and the weakening of the consumer household activities (HFCE) as revealed by the 4Q 2014 GDP data provided by the government, as explained here.

The rising account of store vacancies at shopping malls appear as real world (not statistical) symptoms of this.

Yet ironically, the supply side (housing, shopping malls, hotel and related industries) continues to project consumer trends as perpetually headed to the sky for them to borrow and build with ferocity. For instance, the daughter of the Philippines' richest tycoon anchors her firm's expansion projects largely on remittances as posted here

The end result from the widely divergent expectations and activities will be a huge or massive excess capacity mostly financed by debt! 

And yet the sellside industry, expects earnings growth rate for the Phisix in 2015 to be at the mid teens. If current trends continue, then they will not only miss by a mile or by an ocean but by a galaxy!

And whatever strength by the peso, or its outperformance in the region, will be further exposed if such trends continue.

Is it a wonder why the BSP chief adamantly insists of deflationary risks in his latest speeches?

Phisix 7,800: The Earnings Growth Mirage

Unpopular ideas can be silenced, and inconvenient facts kept dark, without the need for any official ban. Anyone who has lived long in a foreign country will know of instances of sensational items of news — things which on their own merits would get the big headlines-being kept right out of the British press, not because the Government intervened but because of a general tacit agreement that ‘it wouldn’t do’ to mention that particular fact. So far as the daily newspapers go, this is easy to understand. The British press is extremely centralised, and most of it is owned by wealthy men who have every motive to be dishonest on certain important topics. But the same kind of veiled censorship also operates in books and periodicals, as well as in plays, films and radio. At any given moment there is an orthodoxy, a body of ideas which it is assumed that all right-thinking people will accept without question. It is not exactly forbidden to say this, that or the other, but it is ‘not done’ to say it, just as in mid-Victorian times it was ‘not done’ to mention trousers in the presence of a lady. Anyone who challenges the prevailing orthodoxy finds himself silenced with surprising effectiveness. A genuinely unfashionable opinion is almost never given a fair hearing, either in the popular press or in the highbrow periodicals.-George Orwell

In this issue

Phisix 7,800: The Earnings Growth Mirage

-Introduction: PSE Facts

-The Interaction between EPS Growth and Interest Rates

-Phisix Returns Careens Away From Reality

-Sectoral EPS Growth Have ALL Been Declining!

-PSE 30 EPS Growth Rates Reveals that This Time Has NOT Been Different!

-DEBT EQUITY RATIO as Barrier to Earnings Growth

-The Four Horsemen to Earnings Growth

-The Fourth Horseman: Soaring US Dollar

Phisix 7,800: The Earnings Growth Mirage

Introduction: PSE Facts

The markets have been absurdly consumed by misperceptions.

As I wrote last January[1],

When stock market returns outpace earnings or book value growth, the result is price multiple expansions. This is why current levels of PE ratios are at 30, 40, 50 and PBVs are at 4,5,6,7. This is NOT about G-R-O-W-T-H but about high roller gambling which relies on the greater fool theory or of fools buying overpriced securities in the hope to pass on to an even greater fool at even higher prices—all in the name of G-R-O-W-T-H!

In the following outlook, I use PSE’s empirical findings to establish the facts and trends of the earnings growth.

The same data provides us plenteous insights that would not only would layout the growth blueprint of the future, but importantly either affirm or falsify popularly embraced wisdom such as current record highs has been about G-R-O-W-T-H as seen by media’s growth projections for 2014 and for 2015, and the perception that structural changes in the economy would tolerate current valuations to significantly depart from historical norms or “this time is different”.

I culled and assembled from the PSE’s monthly January reports the financial valuation numbers for the month of December from 2007-2014 as shown from the table above. 

This would be the basis for my appraisal of the validity of popular perception.

The numbers have mostly been based on third quarter financial statements submitted by the listed firms to the PSE. The end of the year results will be out in the PSE’s April report. I include below the PERs of each members of the Phisix composite.

The table above consists of Price Earnings Ratio (PER) in yellow background, Book Value (BV), Debt Equity Ratio (DER) in green backdrop, annual returns of the benchmark in orange and the ratio of returns relative to earnings growth in blue.

From the numbers indicated, I derived the implied EPS and Book Value in order to generate their annual growth rates.

In this report we will not deal with the Book Value.

Some notes:

-While the starting point of the data set will be from the year end of 2007, annual changes will begin from 2008. In the occasion where I use compounded growth rates, since the above numbers are based from end of the year, the period used will be from the succeeding year until the last reference point. For instance, 2008-2014 will cover 6 years.

-The Phisix composite index has had marginal changes in the firms included in the basket over the stated period. Considering liquidity (market volume)—aside from free market float—as the two principal criteria for the inclusion of a firm to the elite basket, the composite indices of the major benchmark and of its subset, the different sectors, have represented the most popular issues. The PSE has announced changes in the composition of the sectoral indices to be implemented next week, March 16, 2015

Since 2008 serves as the nadir of the current cycle, the beginning reference point should magnify whatever numbers seen from the above. For instance, the Phisix posted a CAGR of 25.25% from yearend 2008 to yearend 2014. Over the same period, the equivalent EPS CAGR has been at 8.62%. This means that the market paid an astounding 193% premium on earnings growth each year! This explains how multiple expansions have been the key driver of the Phisix which is why the current levels of valuation.

Of course the numbers above shouldn’t be seen only from a single standpoint for the simple reason that annual changes and sectoral performances have been variable

So here I will adhere to the BSP chief’s gem of an advice to journalists as noted last week[2].

Economic numbers rarely tell the complete story when taken at face value. Therefore, a responsible journalist who seeks to offer readers a fuller appreciation of the information will examine the figures within a broader context or against an array of other relevant indicators.

The Interaction between EPS Growth and Interest Rates

Despite headline hallelujahs, the chart of the reported nominal EPS growth can easily be seen as refuting the vaunted G-R-O-W-T-H story. Since 2010, EPS growth rates have steadily been in a decline!

Here is a terse chronicle or historical narrative of the EPS’s history.

The Great Financial Recession took the sails out of the Phisix. While EPS growth remained positive its growth rate fell by 20.9% in 2008.

Then, the Philippine economy had a relatively clean balance sheet with debts at vastly lower levels than today. I’m not referring to Debt Equity Ratio but to aggregate debt.

Yet let me interject a short history on Philippine interest rates

Remember that the BSP embarked on a target to radically alter the structure of the Philippine economy through the monetary tool of ‘boosting aggregate domestic demand’ by easing through a series of rate cuts. The BSP slashed interest rates from 6% to 4% in 2009. 

In 2Q 2011, the BSP partly reversed course to raise rates by 50 basis points. So from 4% official rates went by 50 bps to 4.5%

However the BSP had an immediate change of mind and engaged into another succession rate slashing activities from yearend 2011 until the 3Q of 2012. In total, the BSP trimmed 100 basis points to from 4.5% to 3.5%.

The BSP maintained rates from 2012 until rampaging food prices and financial assets forced them to raise official policy rates twice during the third quarter of last year from 3.5% to 4%.

Now the link between interest rates and earnings growth

The frantic reduction of interest rates in 2009 apparently juiced up the Phisix earnings growth for two years. The rate of earnings growth registered a spectacular 26% and 28% in 2009 and 2010 respectively.

Apparently, the overheating of earning growth rates was unsustainable, so this came under pressure. The reversion to the mean flexed its muscle and evidently forced the downside adjustments.

So coming from two successive years of earnings growth juggernaut, earnings growth rate recoiled and stumbled by 20.24% at almost at the same scale with 2008. This coincided with the BSP’s rate increases in 2011.

So earnings growth backpedaled when the BSP slightly tightened.

However, the sharp downturn EPS growth had been reversed in conjunction with the BSP’s second wave of rate cuts from late 2011 to 3Q 2012.

In 2012, earnings growth jumped by another splendid 16.46%. But this has been far less than the pace of 2009 and 2010.

This shows that when the BSP eased earnings growth temporarily revived.

But from then, things turned downhill, EPS grew by less than half of 2012 levels or at 7.94% in 2013 and worst, in 2014 EPS growth eked out only 1.63%!

So despite the sustained easing mode by the BSP, the EPS growth momentum subsided. The downshift has been exacerbated by the BSP’s minor tightening in 2014.

In effect, the positive impact from interest rate manipulations has been subject to the law of diminishing returns. The tightening only compounded on this dynamic.

As a side note, again full year EPS will be revealed in the April report.

Yet to see a rebound in line with popular expectations means 4Q earnings will need to explode.

For instance media says that 2014 earnings will come at 6%. Given the 1.63% EPS growth for three quarters, for this to happen, 4Q earnings will have to explode by 19%!!!

This only demonstrates how EPS growth projections have been immensely overrated.

Phisix Returns Careens Away From Reality

Now that we have dealt with earnings and interest rates, we look at returns.

With the exception of 2014, in the past, and in general, Phisix returns largely tracked the earnings performance (see left window). In short, markets behaved relatively rationally.

The Phisix zoomed for two years, 63% in 2009 and 38% in 2010, in response to the fabulous rebound of earnings coming off the 2008 meltdown based on the relatively sound fundamentals and the BSP easing as noted above.

When earnings growth retrenched in 2011 in conjunction with the BSP hikes, the Phisix posted only a meager 4% return for the year. So the market’s priced in the EPS growth downturn.

Ironically, while the 2011 earnings growth performance was almost equal to 2008, with both scoring a significant retrenchment in growth rates, returns revealed immense disparity; the Phisix lost 48% in 2008 as against a positive 4% for 2011.

Aside from liquidity issues, the difference reflects on the prevailing sentiment where the former had been bogged down from an overseas contagion while the latter manifested a residual carryover of optimism from the previous 2009-2010 run. But still returns then somewhat reflected on earning activities.

The BSP easing in 2012 which again had been accompanied by an EPS growth rebound had the Phisix posting a magnificent 33% return.

The bullish sentiment spilled over to the first semester of 2013 but was truncated by the 2013 taper tantrum selloff.

Yet that 2H selloff brought Phisix valuations closer to earth. Valuations was high but not at outlandish levels.

In 2014, the wheels just came off.

The suppressed bullish sentiment from 2012 to 1H 2013 came back with fury.

In 2014, while EPS grew by a speck (1.63%), returns simply went off tangent and blasted away.

In the past, the return-EPS growth ratio, which reflected on market’s assessment on earnings or the premium or discount paid relative to earnings, hardly went beyond 100%.

That all changed in 2014 where the market paid an astronomical 13x earnings growth (left window)!!!

This is the reason why the Phisix PER in 2014 soared by 20% to 21.84 from 18.08 in 2013.

Yet the current departure between returns and valuation levels has been representative of this massive and still ballooning divergence!

Sectoral EPS Growth Have ALL Been Declining!

It would not do justice for us to look at the Phisix without examining the sectoral performance in the lens of earnings growth.

As of Friday’s close, the holding sector dominates the share of the Phisix with a 35.41% weighting. This is followed by Industrial 17.09%, property 16.04%, services 15.28% financial 14.88% and mining 1.3%.

So given that the holding and industrial sector plays the lead role as the major influencers of the Phisix, I show them first. 

Yet for both sectors, EPS growth apparently has moved in tandem with that of the major benchmark. They have all underperformed expectations.

The highly popular property sector, which has been sizzling hot today and outperforming the rest and responsible for much of the lifting of the Phisix to current record highs produced a surprisingly negative (-7.4%) growth in 2014!

The finance sector departed from the majors, posting two hefty EPS growth in 2012 and 2013, but this seem to have faded as the sector’s growth rate shrank to a paltry .8% in 2014.

On the other hand, the service sector, which has underperformed in 2010-2012, rebounded strongly in 2013 but gains appear to have been short-lived as EPS growth posted only 6.33% last year.

Yet the service sector had been the best performer in 2014 in terms of EPS growth compared to the rest including the most popular and most influential peers.

Unfortunately the service sector had been the industry laggard in terms of returns, posting only 13.94% in 2014 when the Phisix celebrated a 22.76% buoyed mostly by the biggest three sectors. So the present state of the domestic markets have been rewarding hype and at the same time punishing the real performer.

In essence, December 2014 underperformance had been broad based as it reflected on ALL the aforementioned major industries.

What media sells as G-R-O-W-T-H has really been a deviation from reality.

PSE 30 EPS Growth Rates Reveals that This Time Has NOT Been Different!

The above represents the Phisix composite members and their respective EPS from 2007 to 2014.

Given the facts that PSE’s EPS growth has been declining for the last three years, and where the decline has been a phenomenon that has been shared by three major sectors and lastly that in 2014 all sectors had performed dismally, my focus will be on the EPS growth performance during this period 2012-2014.

From the above table we get the following insights:

-There have been only SIX issues which has consistently delivered positive growth (blue font), specifically ALI, URC, JFC, ICT, RLC and MER. (blue font)

-There have been only FIVE issues, namely ALI, URC, JFC, ICT, and MER, which delivered an average growth of above 10% over the past 3 years!

-Last year, 10 issues, only one-third of the basket, posted growth of 10% see above yellow background.

-Last year, 13 issues posted NEGATIVE growth (red font).

-Most earnings of the individual firms has been very volatile.

So there had been more negative growth than positive growth with over 10%.

All these converge to demonstrate why the PSE’s EPS grew by only 1.63% in 2014.

Which is the exception and which is the rule, outperformance or mediocre earnings activities?

So has there been a structural change in earnings growth to warrant an alleged “new normal” of high valuations?

Based on the above, the answer is a clear NO.

Understanding Media’s Bubble Promotion; IIF’s Warning on Buyside Institutions

The above only reveals what media and their quoted experts/industry leaders see as “new normal” has actually been about survivorship bias—the error of focusing on the winners or the visible—in combination with fallacy of composition—what is true in some parts is interpreted as true for the whole.

Yet we have to understand where such sentiment has been coming from.

When buyside institutions declare “new normal” of high valuations they are most likely speaking to reflect on how they manage their balance sheets. I previously noted that this signifies a yellow flag. Remember[3]?

Finally I’d be very concern about buyside institutions selling products heavily based on expectations of beyond historical average returns. Those rose colored glasses may be a function of endowment effect—people value things highly because they own them. If the portfolio of buyside institutions have been largely weighted on such expectations, and if such expectations fail to take hold, a big mismatch in the asset—liability could result to a lot of pain for the clients.

The Institute of International Finance a consortium or a global association or trade group of financial institutions with nearly 500 members in 70 countries last week warned about the imbalances being accumulated on the asset-liability matching process by the buyside (pensions and insurance) industry due to the low interest rate regime.

Given that low interest rates have effectively increased present value of liabilities of such institutions, low interest rates effectively spurred the widening of the gap between assets and liabilities. Add to these, regulatory obstacles have created “shortages” of assets that these institutions are allowed to hold on their balance sheets.

So with the gulf between liabilities and assets, buyside institutions have resorted to incredibly perilous risk taking of using “various investment strategies” intended to “produce equity-like returns”. 

On a global scale, such institutions aside from boosting holdings of corporate and foreign bonds to record levels, have vastly increased exposure on ETFs, high dividend yield stocks, unhedged usually options based directional trading and carry trades. Worst, in order to produce equity like returns, buyside have used enormous amounts of leverage to finance such transactions.

Addressing buyside institutions, here is the IIF’s latest warning[4]: (bold mine)

The longer lower rates and net negative supply of high-quality government bonds persists, the more pressure is put on long-term investors to take on extra risk to generate income. These risk exposures would accumulate and render the financial system more fragile as long players become more exposed to a severe market downturn. Moreover, the phenomenon of “savings glut” chasing bonds could become endogenous, keeping bond yields low and requiring additional savings—thus prolonging the low-rate environment and supporting the buildup of even more risks.

The IIF essentially validates my yellow flag warning.

So when representatives of domestic buyside institutions declare that “this time is different”, they are symptomatic of the dynamic of “more pressure is put on long-term investors to take on extra risk to generate income”. It’s also sign of endowment bias—ascribing more value to things merely because they own them. In particular, they are expressive of their investment strategies employed for balance sheet matching.

In short, those “pressures” to match asset and liabilities have now been conveyed as rationalizing high valuations with “this time is different”.

Yellow flag it is for many financial institutions.

Of course the incentives of the buyside and the sellside industries are different.

Yet it would be really off the mark for anyone to say that media’s sentiment represents the consensus.

Take the stock market. There are only about 600,000+ invested directly at stocks or .6% of the population. If we add those indirect investors via mutual fund, UITFs and others this would be about 2-3% of the population. Even if we give the benefit of the doubt that there have been 5% directly or indirectly exposed to the market this means 95% have not been invested.

95% is THE consensus. But you don’t hear them. They are the silent majority. That’s because they are not organized. Also they don’t pay media advertising revenues.

Except for me, hardly anyone speaks in behalf of them. So for instance, when I get reprimanded by an industry leader for not towing the line, where the “consensus” (appeal to majority) has been used as a pretext to justify current mania, what has been talked about have really been about the sentiment of the consensus of the industry—again organized interest groups benefiting from the mania.

The organized interest groups are in control of communications in media. Media expresses on their sentiments and not of the silent majority. Even if many in the public shares media’s sentiment, for as long as they are not participants in the marketplace they remain uncommitted to such interest groups. Action speaks louder than words—demonstrated preference.

But again this would be an issue for another day.

DEBT EQUITY RATIO as Barrier to Earnings Growth

This leads to next ingredient to the stew of interest rates, earnings and growth; the role of debt as expressed in the PSE report as Debt Equity Ratio (DER).

From 2008 to 2014, the suppression of DER growth boosted EPS growth. On the other hand, a surge in DER growth has impeded EPS growth (see left window).

Correlation is not causation but there is a link. Debt is a liability. It is included in a company’s operating cost. If a company acquires debt and if such increase in costs will not be negated by an increase in revenues or in margins, then debt servicing will gnaw at the company’s earnings.

So the inverse fluctuations from DER and EPS seem like a manifestation of such dynamic.

The huge debt buildup has also been broad based in terms sectoral performance and a largely a 2013 origin dynamic.

DERs of all the major sectors have spiked in 2013. In 2014, DERs continued to rise in the holding industry, finance and service. The growth rates have declined in the industrials and the property sector.

I would guess that those numbers have been underrepresented. That’s because BSP’s bank loans to the general economy especially to the property sector have risen through 3Q 2014.

Also I believe that there has been a lot of off balance sheet loan transactions aside from the existence of the domestic shadow banking system as previously reported by the World Bank.

In addition I believe that balance sheets have been bloated from monetary inflation to possibly overstate equity values.

So add to the DER story the BSP interest rate history we get an idea how the Phisix EPS growth story has been shaped.

Those interest rate cuts of 2009 which ignited the magnificent EPS growth effectively reduced DERs. But again we see the law of diminishing at work. The succeeding rate cuts in 2012, not only reduced EPS growth trends, but likewise combusted the PSE’s DERs past 2008 highs since 2013!

So debt must have likely been a key factor in depressing EPS growth in the past and so will they affect EPS growth in the future.

Debt accounts for as just ONE of major barriers on why those high growth expectations from industry consensus will likely miss overstated targets by a galaxy.

The Four Horsemen to Earnings Growth

Yet I will add FOUR more obstacles that have not been included in the PSE report.

Three are domestic, which I have previously discussed, has been part of the Philippine government’s puffed up 6.9% 4Q GDP.

The fourth is exogenous.

Despite the panoply of media cheerleading on selective statistics, embedded in the government’s economic growth statistics has been substantial ongoing challenges in investments, household spending activities and even retail and wholesale trade as noted here.

If investments won’t pick up where will real economic growth come from that should filter into earnings? Why have households been pulling back? Why has growth in the retail industry plummeted in 4Q 2014?

If household spending remains lackluster where will malls, condos, casinos and hotels or the PSE’s top line come from and how will earnings growth be generated? How about the surge inventory from wholesale activities?

And how about those debt that has financed all these activities?

Also why does the BSP chief insist in his deflation spiel to even lecture journalists on how to see events in the framework of deflation?

The Fourth Horseman: Soaring US Dollar

Now the fourth factor: the USD-peso

Last week, Asian currencies had practically been hammered.

Against the USD, the South Korean won collapsed by about 2.7%, the Indonesian rupiah was smoked anew by about 1.7%, and the Singapore dollar got smashed 1.1%.

The most recent currency star of Asia, the Indian rupee was not invincible after all. The rupee was battered by 1.2%. This has reduced the rupee’s year-to-date gains which still remain positive. The rupees’ smashed up have likely been due to her ‘surprise’ interest rate cut along with South Korea.

As a side note, it’s a surprise to media but not a surprise for me as I expect Asian currencies, including the BSP to jump into the interest rate cutting bandwagon. 

The Thai baht lost 1.07%, the Malaysian ringgit fell .97%, the Taiwan dollar slipped .59% while the Philippine peso lost only .47%. The Chinese currency the yuan was the best performer to date to rise by .07%.

And speaking of central bank panics, add to this week’s rate cutting has been Russia and Serbia.

Year to date except again for the rupee, Taiwan dollar and the Philippine peso Asian currency has been substantially weaker. For now, the Philippine peso now takes on the leadership but for how long?

There are two major transmission mechanisms for currency weakness, one is through imports, and the other is through foreign denominated debt.

On a global scale, with the US dollar index hitting 100, a multiyear high, this bring into the light the $9 trillion US Dollar based credit to non banks OUTSIDE the US (see left), and the potential harbinger for a colossal event risk (right) which in the past has been “associated with major market events such as 1981 Volker shock, 1992 ERM crisis, Lehman in 2008 and so on” according to Bank of America Merrill Lynch/Business Insider.

Question now is what happens when one of these Asian nations suffer from a credit event? Will this be isolated or will history repeat?

It appears that the industry would like to anchor on the former, while the latter is the likely outcome.

A lot of people think in terms of satisfying present convenience. As Bill Bonner of Agora Publishing writes[5]:

People come to think what they must think when they must think it.

This time will NOT be different. The obverse side of every mania is a crash.

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[1] See Phisix at Record 7,400: Be Fearful When Others Are Greedy January 12, 2015

[2] See Phisix 7,800: Record Phisix as the BSP Continues with Deflation Spiel! March 9, 2015

[3] See Phisix 7,800: Record Stocks, Incredible Misperceptions February 23, 2015

[4] Institute of International Finance, Capital Markets Monitor: A Fundamental “Asset-Liability Mismatch:” Investing in a Low-Rate Environment March 4, 2015

[5] Bill Bonner How This Great Race to Disaster Finally Ends January 9, 2015