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A storm of profits
“Human nature is such that it will readily pay more to protect a loss
than risk the same amount of money to achieve a much larger gain”
The following pages present an analysis on the Brazil Market and how
this could provide an expedient opportunity.
Andrew Shawn
The Facts:
Trees do not grow to the Sky but in the eyes of today’s Investors, Brazil is considered
the exception to the rule. As the dream of the Commodity boom gained momentum
in the financial markets a major development occurred in Brazil. On the 27th of
October 2002 at 57 years of age, with approximately 53 Million votes Luiz Inácio
Lula da Silva got elected as President of Brazil
Brazil 27/10/2002
From the above figures in US dollar terms the Bovespa surged by an incredible
1350% (One thousand Three hundred and Fifty Percent) between October 2002 and
today. The US Dow Futures during the same period managed a meager 46% rally.
In layman terms assume you had gone long, investing USD 100,000 on a synthetic
Bovespa futures contract.* Further assume margin requirements averaged USD
2,500 per contract (very conservative). You would consequently be able to carry at
least 40 contracts
* The above assumes no pyramiding of ones position or option leveraging. It further assumes the starting equity on
the account was more than the sum invested. This allows the portfolio to hold on through the volatile climate and
prevents any margin calls from forcing liquidation of portfolio positions.
Phase I
During the early stages of the rally most participants were not leveraged. Brazil
exports included:
- Iron ore, highly prized by major steel makers in China, Europe, India, Korea and
Russia.
- It was the world’s largest exporter of coffee, sugar, cattle, orange juice.
Funds flowing into Brazil were healthy. Companies involved at this stage would qualify
as Minsky’s “hedged firms”. Participants were content with dividends. Joint ventures
with private export companies had enough cash to sustain an adverse market reaction.
Phase II
As profits soared from Brazil Investments, a surging Brazil local currency acted as the
best ambassador. The first movers drew in additional players, who inevitably engaged
in leverage to improve the yields earned by the original cash players. The best source
to employ leverage is the futures market. Volume participation on the BM&F exchange
soared to new highs. The ibovespa Futures began an impressive rally.
In 2002 Brazil exports for the month of February were 3.6 Billion but by July 2006
stood at 13.6 Billion. The correlation between monthly Brazilian exports and the CRB
Index was uncanny.
Phase III
It became fairly obvious to the authorities that the rise the $REAL and the Bovespa
were experiencing exaggerated the performance of the underlying fundamental
economy. To bring them inline the Central Bank attempted to reign in on the speed
with which the $REAL was soaring.
The Brazil Central bank (BOB) assumed the rally in the underlying local currency
BRL/USD was due to the high global Interest rate differentials. On October 14th 2002
Brazil Selic (Short term rates) stood at 21%.
Market participants reacted to every successive short term interest rate cut like Indians
to Wildfire. Every cut was considered a further stimulus for the local economy.
Extra liquidity and the slush of cash added impetus to the Bovespa rally, compounding
belief in the commodity boom and sucking in more hot money.
How often have you heard the famous fatal five words: “This time it is different” The
new paradigm of tectonic shifts in the global economic system is found on a plethora
of books published in the recent years on BRICS.
- Tradable Indexes tracking Brazil from ETFs to accessible futures have become
ubiquitous. The CME launch the CMEGroup-BM&FBovespa (www.cmegroup-
bmfbovespa.com.br).
- Open Interest on Bovespa Futures contracts hit new all time highs
- FT and other publications are loath with praise of the Brazil miracle. Having gone
180° from needing money to prevent a virtual collapse of their currency and
financial system to seating on an excess of currency reserves.
- Behold a Sovereign Wealth Fund from Brazil. Minister of the Economy Mr. Guido
Mantega intends to fast track the proposal for the creation of Brazil’s SWF within
the next four months. The SWF is estimated to be capitalized with 200 to 300
Billion US Dollars.
- Always late to the party but never absent are the global rating agencies. How they
are still able to have any credibility in the Investment world despite the countless
times of their late arrival to the party when the music has stopped is an
accomplishment in its own right.
o Standard & Poor raises the countries sovereign credit rating to Investment
Grade
- Those new ratings are supposed to open the floodgates to Institutional money
which previously couldn’t invest in Brazilian debt because of the “Non Investment
grade status”
The only thing that was missing in this Cinderella story was an Irving Fisher statement
of 1929 “Stock prices have reached what looks like a permanently high plateau”. The
above statement by President Lula da Silva comes really close.
At the current juncture the Central Bank of Brazil has twice raised the Selic (Brazil
short term Interest rates) to 12.25 (Over 100 basis points from the lows of 11.25). The
investment paradigm interpret these interest rate hike movements as positive for the
$REAL due to increased interest rate differentials.
My liquidity heuristic contends that as the above rate hike continue to occur rising
interest rates will reduce liquidity, slowing the Bovespa’s upward momentum. A halt in
the Bovespa’s upward momentum will attract less hot money, weakening the $REAL.
The weakening $REAL should be seen as the Meta indicator for a nascent vicious
downward cycle of a falling Bovespa back to earth.
Divergences have become visible in the commodity driven equity markets. The SPI 200
Futures (Australian Market) is off all time highs as is the New Zealand Markets. The
strong correlation indicator between the S&P Canada 60 (Canadian Stock Market) and
the Bovespa has turned neutral from its previous bullish reading.
Conclusion:
The asymmetrical nature of time during Market rallies and sell offs (Markets sell offs
take between half to one fourth the time it took during the rally) indicate that the
Bovespa could give up the gains it made during the last six years within a one year
period.
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