Brazil Storm Of Profits

Brazil – Bovespa $Real (BM&F) A storm of profits

Reflexivity Capital Group All rights Reserved

Brazil - Storm of Profits As a participant of the financial markets for over a decade I have found busts in financial bubbles to have provided me with the most incredible opportunities for expedient returns. I have further to our dismay discovered that it is very challenging to get an investors attention about a pending disaster and the excessive short term gains that can be made by coming along for the journey. The bulk of them are too taken in with the existing euphoria of the time that they end up considered one a heretic, a mad man or at best someone to be avoided at all costs. If someone had offered you the opportunity to participate in an investment pool in January 2000 to sell short Internet stocks just as they were hitting all time highs would you have taken it? How about participating in a pool to sell short Investment banks in June of last year before the subprime bubble broke? In each case had you participated a windfall of profits would have been realized in very short time frame. “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 pending bust in Brazil presents an opportunity of a lifetime. The Bovespa (Brazil Stock Index) has surged over 1350% between 2002 and today. Its Currency has literally doubled against the US Dollar and had even some circles forecasting it would touch parity. The following pages present an analysis on the Brazil Market and how this could provide an expedient opportunity.

Andrew Shawn June 16th 2008

Introduction

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 Brazil Stock Market Index Brazil $REAL Brazil Central Bank Rates

Bovespa USD/BRL: Selic

(Exchange) closed at 10226 level $Real closed at 3.61 to the US Dollar Copom BOB Interest rates 22%

Bovespa USD/BRL Selic

(Exchange) closed at 67204 level $Real closed at 1.636 to the US Dollar Copom BOB Interest rates 12.25%

Brazil Today 16/6/2008 Brazil Stock Market Index Brazil $REAL Brazil Central Bank Rates

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

27/10/2002 16/6/2008

40 Bovespa (BOVX2) 40 Bovespa (BOVM8)

= 40 x 10226 x 1/3.61 = 113,307.50 USD = 40 x 67204 x 1/1.636 = 1,643,129 USD

100,000 invested would have returned nearly TWO MILLION US DOLLARS

* 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.

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Conceptual Framework: Analyzing market developments from a Hyman Minsky prospective, we posit that structural developments occurred in 1999 / 2000 as the nascent Commodities Boom cycle within the BRIC countries sucked up capital from the center. An ideological paradigm shift occurred championed by Jim Rogers. Phase I During the early stages of the rally most participants were not leveraged. exports included:

Brazil

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Iron ore, highly prized by major steel makers in China, Europe, India, Korea and Russia.

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It was the world’s largest exporter of coffee, sugar, cattle, orange juice.

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In 2006 it surpassed the US as the biggest exporter of soybeans.

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. Recursive Investment Relationship: Belief in the surging real economy due to the commodity boom continued to attract Speculative Capital flows into Brazil, pushing the $Real higher. The slush of foreign cash provided a benign environment conducive for the local stock market rally. As the Bovespa rallied traders belief in the fundamentals of the Brazilian magic became validated.

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The RATIONAL assumption traders made was to posit the Bovespa as a proxy for the local Economy. The rally in the Bovespa validates and reconfirms the belief in the commodity boom. This created a benign recursive loop of attracting further speculative capital flows into Brazil; In turn causing the REAL (BRL/USD) to rally, sending more liquidity into the market, pushing the Bovespa higher … ad absurdum 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%.

The BOB intervened, cutting short term Interest rates steadily from the highs of 21% down to 11.25%.

The Central Bank’s intervention exacerbated the recursive circular relationship, producing the opposite effect of what they had intended. 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.

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Twilight Zone – Characterisitics of a Bubble 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. -

Margins on Brazil Instruments have increased drastically.

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Tradable Indexes tracking Brazil from ETFs to accessible futures have become ubiquitous. The CME launch the CMEGroup-BM&FBovespa (www.cmegroupbmfbovespa.com.br).

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Trade volumes on the Bovespa hit new all time highs

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Open Interest on Bovespa Futures contracts hit new all time highs

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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.

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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.

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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.

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Fitch Raises brazil to Investment Grade

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Standard & Poor raises the countries sovereign credit rating to Investment Grade

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R&I of Japan raises Brazil debt to Investment Grade

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DBRS of Canada raises Brazil debt 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”

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The President comes out to confess his belief in the Magic of the Market. Honored by BM&FBOVESPA for Brazil’s Investment grade rating, President Lula reiterated that the goal is to maintain economic stability. “Also in the capital market sector, Brazil is no longer a colony: It is a developed nation.” This statement was made on the 16th of June, 2008 by President Luiz Inácio Lula da Silva (Lula) during a ceremony where he was honored by BM&FBOVESPA, the world’s third largest exchange by market value, for the country’s investment grade rating. 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. First Signs of a pending Bust: 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.

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Divergences 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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Charts Bovespa (2002-2008)

BRL/USD Currency (Brazil Real / US Dollar)

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