June 23, 2013 – Divergences and Coordination Problems

In James Surowiecki’s book “The Wisdom of Crowds”, he writes in chapter 5 an observation about William H Whyte’s work on what is now known as the “Street Life Project.”

What Whyte saw – and made us see – was the beauty of a well coordinated crowd, in which lots of small, subtle adjustments in pace and stride and direction add up to a relatively smooth and efficient flow.  

Pedestrians are constantly anticipating each other’s behavior.  No one tells them where or when or how to walk.  Instead, they all decide for themselves what they’ll do based on their best guess of what everyone else will do.  And somehow it usually works out well.  There is a kind of collective genius at play here…

What defines a coordination problem is that to solve it, a person has to think not only about what he believes the right answer is but also about what other people think the right answer is.   That is because what each person does affects and depends on what everyone else will do, and vice versa.

How can people voluntarily that is, without anyone telling them what to do, make their actions fit together in an efficient and orderly way?  Those answers often involve factors that shape a crowd’s behavior and are also shaped by it.  When it comes to coordination problems, independent decision making is pointless since what I’m willing to do depends on what I think you’re going to do, and vice versa.  As a result, there’s no guarantee that groups will come up with smart solutions. 

When what people want to do depends on what everyone else wants to do, every decision affects every other decision, and there is no outside reference point that can stop the self-reflexive spiral.  

In many situations, there are salient landmarks or focal points upon which people’s expectations converge.  These points are important for a couple of reasons.  First they show that people can find their way to collectively beneficial results not only without centralized direction but also without even talking to each other.  People can often concert their intentions and expectations with others if each knows that the other is trying to do the same.

Conventions obviously maintain order and stability.  Conventions allows us to deal with certain situations without thinking much about them, and when it comes to coordination problems, they allow groups of disparate, unconnected people to organize themselves with relative ease and an absence of conflict.

The most successful norms are internalized.

All the buyers and sellers are perfectly rational , meaning that they have a clear sense of how to maximize their self-interest.  And every buyer and seller has access to a complete set of contracts that cover every conceivable state of the world, which means that they can insure themselves against any eventuality.  But no market is like this.   Human beings don’t have complete information.  They have private, limited information.  It may be valuable information and it may be accurate (or it may be useless and false), but it is always partial.  Human beings aren’t perfectly rational either.  They may want for the most part to maximize their self interest but they aren’t always sure how to do that and they’re often willing to settle for less than perfect outcomes.  When people buy and sell stocks, the results are more volatile and erratic particularly due to emotions  Also, if wealth is unevenly distributed before people start to trade in a market, it’s not going to be any more evenly distributed afterward.  A well-functioning market will make everyone better off than they were when trading began, but better off compared to what they were, not compared to anyone else.  On the other hand, better off is better off.

Everyone would end up with the amount of money they deserved.

*****

An example of  a salient landmark and conventions are the tools normally used to interpret a market’s health.  Most notably, technical analysis is a tool used by people all over the world.  A lot of Filipinos already use this.  Another key convention that I find useful as a leading indicator are USDPHP, US 10 year treasury yields and Philippine treasury yields.  The Philippine government  10 year treasury bond yields often dictate what the risk free rate should be used in pricing Philippine equities. With a repricing on the US Treasury, all other asset classes such as bonds, equities and currencies get re-priced.  In general, A spike in bond yields causes bonds to fall as well as stock prices to tank primarily due to lower discounted cash flows when higher discount rates are used.

http://asianbondsonline.adb.org/philippines/data/marketwatch.php?code=government_bond_yields

http://www.tradingeconomics.com/philippines/government-bond-yield

10 year treasuryphilippine treasury

 

10 year bond overview

 

I show the charts of the US Treasuries and the Philippine Treasuries.  While there has been a spike in yields from its lows since May 2013, it is notable to see that the 10 year government bond is still at 3.94%, a far cry from the 6% average that the Philippines had to pay to its creditors prior to investment grade status and still below the 4.5% yields that Philippines had to pay to its creditors for any borrowings.   There is however a divergence in the bond markets with the stock markets, as some Philippine companies are being priced today as though we are headed to a 6% junk status risk free rate (and discount rates of 10-12% in some DCF models.)

Similarly, there is no asset reflation.  The monetary board of the Philippines has maintained the policy rate as inflation outlook is benign at 2-3%.    Liquidity that is sitting in Central banks is seen to be parking too much into non-productive assets.  Thus the BSP dictated the special deposit accounts (SDAs) to encourage more productive activities (encourage investments either in ROPs, equities, properties, hard asset investments, expand stores and credit lines et al) in a non-inflationary environment to boost consumption, add jobs and further make more government expenditures especially in terms of infrastructure (airports, roads, schools et al).  The BSP is promoting non-inflationary growth, not imbalances and excesses.

Also worth noting is that the strong dollar and the depreciation of the USDPHP is good for the Ph$ilippine economy.  So long as USD is at a sweet spot of 42-44, additional OFW remittances which is forecasted at $22.5 Bil  for 2013, up from 21.8 Bil last year will encourage additional 40-50 Bil pesos in consumption as Interaksyon notes that these OFW remittances flow back to the economy in the form of food, goods and services.  BPO companies will not only invest more in a USDPHP rate of 43, they will also find it cheaper versus the predecessor 40-41.

See these articles here – http://www.interaksyon.com/business/64232/where-did-ofws-remittances-go-in-2q

http://www.interaksyon.com/business/45395/henry-sy-other-taipans-reaping-benefits-of-ofw-remittances—nscb

 

Granted the volatility,  my personal strategy is to construct defensive and offensive stocks in my portfolio.

1.) Stable and Consistent Income Streams – So long as dividend yields in the stocks that I hold are 4% or greater, these are still better places to park than government bond yields currently trading at 3.94% in the 10 year treasury department.  While there’s no sign of any top in bond yields, a 5% 10 year government bond yield signifies enough panic for me to buy more stocks at ever more depressed levels.  Stable companies with limited cyclicality that trade at less than 10X P/E for 2014 and consumer staples whose decline in commodities provide better earnings prospects are at the back of my head.  A good gauge to pick stocks is to find their historical means and to put a standard deviation 1-2X below for better cushion.

Sector – Consumer Staples, Telcos, Utilities

2.) Strong Dollar Beneficiaries- companies with strong dollar exposures such as BPO and shipping companies also come to mind.

3.) Risk on stocks like rising domestic consumption and beneficiaries of government reforms (PPP, Construction plays) – Possibly when the tide changes in favor of the bulls.

Things to Watch For:

Aquino’s state of the nation address is on 22 July.  Awarding of more PPP projects in 2H13, which strengthens 2014 investment backdrop

 

*****

In any case, while the backdrop for continued gains has diminished, the solid domestic demand is intact for longer time frames (at least until 2015 if you’re a true bear).  Even if the Philippines were to just pose a 6% GDP growth in 2Q13 versus the 1Q13’s 7.8% partly boosted by election spending, slow growth is still seen higher versus previous years where average was a measly 3%. Remittance families will get a windfall from the new USDPHP average of 43 and will sustain earnings growth for most consumer centric companies in the Philippines. With benign inflation and SDA repositioning, getting stuck with some dividend paying companies trading at 10X P/E or less is something I’m comfortable with.  I cannot anticipate exactly what everyone else will do in the short term but as for myself 25% to 50% cash exposure is defensive enough.  I do not need to dash to cash just because all the bears and support levels come screaming at the top of their lungs about how massively overvalued the Philippines has been.  While the lack of possible near term catalysts have been priced in (i.e. investment grade ratings) and more liquidity sappers coming along (two big ticket IPOs such as Robinsons Retail and Travellers dampening liquidity and consumer confidence) as well as some Ghost month scaredy cats, once volatility subsides, a positive bias is my stance.   Philippines’ stronger macro performance will support valuations against a backdrop of softer EM growth. I cannot time the bottom but there are focal points that will be my guide posts.

– Faceless Trader

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