Coming crash from secular overvaluation, falling dollar

This article first appeared in The Edge Financial Daily, on March 1, 2018.
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THEY say history never repeats itself, but it rhymes. If that is true, investors should be extremely wary of the dollar’s decline on the world’s foreign exchanges and Wall Street’s recent move into a “secular overvaluation zone”.

These are the observations of two men with nearly a century of financial market and academic expertise behind them who say US stocks are setting up for an almighty crash.

Unsurprisingly, Robert Aliber, emeritus professor at the University of Chicago and Jonathan Wilmot, a former Credit Suisse investment strategist with over 40 years experience, are a little less sure of when the collapse will come.

But come it will.

The two were on a panel in London last week explaining their gloomy outlook. Wilmot based his analysis on a composite corporate earnings valuation measure going back to the 1850s, and Aliber based his on US dollar cycles since 1980.

First Wilmot.

According to his analysis, US stocks entered the “secular overvaluation zone” in December last year for the 13th time since 1850 and only the seventh time since 1905. Curiously, the prelude to the 1987 crash is not one of them.

Wilmot’s measure of US market valuation is a mix of his own price-to-earnings ratio, real market returns, the relative performance of stocks versus bonds, and corporate earnings. When this goes one standard deviation above the mean, stocks are in the “secular overvaluation zone (SOZ)”.

There is no formula to establish when the market heads south after entering the “zone”. Sometimes it is a few months, sometimes it is three years. The average of all previous “SOZ” episodes is 11 months, during which time equities can rally a further 5% to 10%.

During what Wilmot defines as “true bubbles” in 1929 and the dotcom boom, stocks rose a further 54% and 83% before crashing.

The US stock market has been on the rise since plumbing the post-crisis depths in March 2009. That is a nine-year bull run, the second longest since 1928, according to Yardeni Research.

Even Wall Street’s fiercest cheerleaders recognise at least some parts of the market are on the expensive side.

But once the market turns, it typically falls 30% to 50%, Wilmot says. What will burst the bubble? Usually it is one of three things: a sharp tightening of monetary policy, a major credit event or sudden capital flight by foreign investors.

None appear to be on the horizon. But the same could have been said in early 1987, early 2000 and 2007.

Dollar cycle #4?
Bob Aliber is equally bearish but at the centre of his more panoramic view is the US dollar.

There have been three dollar cycles since 1980, all of which follow a similar pattern of boom followed by bust. We are in the middle of the fourth cycle, Aliber argues.

They go something like this: The “expansive phase” consists of rising investor demand for dollar securities, a stronger dollar, and higher US asset prices. There is then a transition to the “contractive phase” in which demand for dollar securities declines, the dollar falls and US asset prices head south.

There is no unified turning point for capital inflows, the dollar and US asset markets. They can and do turn at different stages. But they all result in major market crashes.

The first cycle was in the 1980s. The dollar peaked in 3Q85 with the Plaza Accord and Aliber estimates that US capital inflows peaked in 3Q86. The “Black Monday” crash of Oct 19, 1987 then followed. It remains by far the biggest one-day fall in Wall Street history.

The second was in the late 1990s. The dollar rose around 50% between 1995 and 2000, during which time the S&P 500 again rose more than threefold. The Nasdaq rose more than sixfold before the tech bubble spectacularly burst and precipitated an 80% slide.

The dollar’s third juiced-up rally was in the mid-2000s even though it fell nominally against a basket of major currencies. In real terms it rose against the Chinese yuan just as China was emerging as America’s single biggest trading partner and a global economic and financial powerhouse, Aliber argues.

The surge in Chinese productivity meant a real depreciation of the yuan and de facto a stronger dollar. China’s boom and demand for oil also fuelled huge appetite for US dollar foreign exchange reserves, which drove a surge in US securities.

Dollar-denominated foreign exchange reserves rose by an estimated US$3 trillion between 2002 and 2008. Much of that went to US Treasury bonds, but large amounts wound their way into US property and stocks. We all know what happened in late 2008.

Aliber reckons we are now in the “transition phase” of the fourth cycle that began in late 2009. The dollar has fallen 15% from its high just over a year ago, while US capital inflows may have peaked in 4Q17 and US stocks on Jan 26.

“If the model is correct, if there is a dollar cycle and capital inflows have peaked, then we can expect a very sharp decline in stock prices. How sharp? That’s hard to say, but it could easily be 50%,” Aliber said. — Reuters