Follow the Money

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The Dow Jones, as well as a number of other equity indices, has recently achieved new all-time price highs. Was it really a question this would occur? We do need to remember we’re now just edging above price levels seen almost six years ago in 2007 and thirteen years ago in early 2000, and on an inflation adjusted basis we’re still close to 20% below old highs. But are we finally emerging from a lost decade plus of very volatile swings in stock prices? Do blue skies lay ahead as we breakout to historic price highs for stocks? Although time will tell, we need to understand a very important change that has taken place over the recent past that is clearly positively influencing many US asset class prices, including US stocks. This change is not borne of optimism, but of fear.

Global central bankers have embarked on a journey “where no man has gone before”. Indefinite and unlimited money printing is now the order of the day. Despite years of already substantial stimulus, over the last six months we’ve seen a number of global central bankers tell us they now stand ready to do whatever it takes in terms of yet further stimulus to reignite their economies. Right now it’s very important to again remember that central bank money printing is academic debasement of respective currencies. The relatively zero sum currency advantage character of an environment where all major central banks are printing means specific central bank activity magnitude and intensity will have the greatest short term impact on financial market and asset class directionality. What we have witnessed recently is that relative currency volatility is increasing globally as heightened and unprecedented central banker actions unfold. It’s this currency volatility that is the important change we are seeing. And the bottom line is that for now, global capital is coming to the United States and US dollar. Not due necessarily to optimism, but rather borne out of fear.

Late last year, Prime Minister Abe was elected in Japan running on a platform of unlimited money printing. Since last October, the value of the Japanese Yen versus the US dollar has declined just shy of 20%. Great for Japanese exporters, but not good for ordinary citizens as imported Japanese energy and food costs go straight up. So far Japanese politicians have suggested wages need to be increased. Good luck with that. Just how can Japanese citizens protect themselves and their savings against the currency debasement being sponsored by their own Central Bank? Easy, move their money out of the country into a currently strong currency like the US dollar. This can be accomplished by the purchase of US bonds, real estate and US stocks – all dollar denominated investment vehicles. A foreign investor looking for currency safety in US stocks would commonly gravitate toward what is perceived as the safest of companies – the Dow Jones blue chips. Global capital moving out of Japan and looking for currency volatility safety is not being driven by optimism; it is being driven by the fear of further domestic currency debasement.

A similar set of circumstances exists in Europe. Southern European economies remain in meaningful trouble. We have seen a very large portion of bank deposits in troubled countries leave the banking system and often move globally. Will the Euro remain as a united currency when there still remains no singular guarantor of European government debt? The question remains open, but for those heavily exposed to the Euro this is a large risk to the relative global value or worth of their Euro denominated capital. Without question European capital has likewise been seeking perceived currency safety, and this is increasing as time passes with no concrete plans for funding and reform in Europe. Like holders of Yen, European capital is scared. It is seeking refuge and stability in US dollar denominated assets over the recent past. And that means real estate, equities and bonds.

This is not Kansas anymore. The US is not the big singular global player it was in prior decades, commanding the economic and financial market stage. Global capital, currencies and financial markets are now a three dimensional chessboard. Actions of global central bankers evoke behavioral responses from investors and capital moves globally. The greatest of behavioral motivators is fear, in this case fear of currency debasement. For now, the US has a huge benefit in being the recipient of very meaningful amounts of scared global capital. To be honest, it’s a benefit we should harvest and avoid squandering, but I’m not holding my breath. This capital is helping to levitate stock and real estate prices and will also have a positive effect on the US economy in isolation. Here on the West Coast we have seen Asian capital increasingly involved in real estate. On the East Coast European capital competes for the same. Is this because US real estate is the bargain of a lifetime? In good part it’s simply global capital on the move as well as moving outside of respective banking systems.

What we are seeing now is not a novel occurrence. During prior World Wars and periods of meaningful global uncertainty, we have seen global capital move and influence markets and asset classes of destination. Scared European capital flooded the United States during WWI in the 1920’s. Canadian Vancouver real estate ascended skyward as Asian capital flooded the area prior to the 1997 hand off of Hong Kong by the UK to the People’s Republic.

We know we continue to experience tepid US economic growth. We also know corporate earnings and revenues are running at one of the lowest growth rates of the current 2009 cycle to date. And yet stock market indices are reaching for the stars. Follow the money. We need to view the movement of capital within a global context. The more global (especially Japanese and European) capital becomes scared and the more relative currency volatility we see as a result of unprecedented global central banker actions, the more that capital will gravitate to dollar denominated assets for now, necessarily inclusive of US equities. We simply need to realize that current stock market strength is in very large part based on this movement of global capital in addition to central banker liquidity, as opposed to US economic or corporate earnings fundamentals specifically. The importance to our investment activities being, if we can identify the correct drivers of asset price movements at any point in time, we can monitor those important drivers for key points of change as will certainly occur somewhere ahead.

Technicians everywhere are fixated on watching the Dow break out, the Dow Theory combined Industrials and Transports break out, the Russell break out, etc. Watching US equity indices priced in the Euro and the Yen I believe will be helpful technically in assessing the health of US equities as far as foreign participation is concerned. As is seen below, recently the S&P broke to new highs above the prior 2007 peak when expressed in Euro’s. The 2000 highs lay far above present levels, but even the S&P itself has not yet broken 2007 nominal price highs in dollar terms. Are Euro based buyers of the dollar via the S&P leading the charge?

spx xeu 8 mar 2013

The S&P expressed in Yen is a bit more interesting. As is clear below, this relationship is approaching meaningful historical resistance. Although the Yen is down shy of 20% versus the dollar since last October, the S&P expressed in Yen is up over 30% since that time. Global capital on the move? If not, then what is this? As a Yen based investor, what is the more interesting trade, the ascending Nikkei in a depreciating currency or the ascending S&P in an ascending currency?

spx xjy 8 mar 2013

As per the old Wall Street adage, follow the money. It has probably never been more important in the current three dimensional chess board that is the global economy and capital markets.

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About Brian Pretti CFA