I’ve talked about the importance of following capital flows in the past. It’s not just watching where the money is flowing, but the interrelationships between investment classes that explains why shifts are occurring and gives clues about what to expect moving forward. This ever-changing nature of the markets is what I find so fascinating.
For example, you can see below that since the Federal Reserve started debasing the US dollar in 2000, the US stock market and the US dollar have moved in opposite directions. The only rallies in the US dollar were during times of economic contraction as money would flood into the US seeking safety and preservation – typically in US government bonds. The trend would reverse when the global economy picked up again since the largest beneficiaries of growth were overseas – typically “BRIC” (Brazil, Russia, India & China) and other emerging nations. This created the “Risk On” and “Risk Off” terms the media likes to use so often to describe if investment capital is seeking higher risk/higher reward investments or high quality “flight to safety” investments.
US dollar (top) vs. S&P 500 (bottom) – 13 years
If we compare the two over the past year, we see the relationship holds until February 1, when both the US dollar AND US stocks began rising together. They’ve almost been moving lockstep ever since.
US dollar (top) vs. S&P 500 (bottom) – 1 year
I noticed this first in the currency markets which is why I’ve been picking up exposure to the US dollar. See here and here. Initially, I thought it was a precursor that stocks were about to see a pullback (given their inverse nature over the past 13 years). Now it’s clearer that this capital flight into the US has been contributing to this extremely resilient rally in stocks. I’ve noted before that China is basically at a point where they have to slow their rate of growth (which is affecting the resource-rich nations like Canada, Australia, etc.), Japan is on a mission to destroy the Yen to end 20+ years of deflation (which is probably going to come back to bite them in the you know what), and Europe is almost beyond repair (I think a breakup of the Eurozone is inevitable – their now imposing capital controls, raising taxes and confiscating bank deposits to try to hold it all together…). The Swiss have pegged their currency to the Euro and many Asian nations are jumping on the devaluation bandwagon to keep up with the fall of the Yen. The US is basically the only option left, and with interest rates still artificially low, everyone continues to pour more money into the rising stock market, fueling it higher.
Euro
British Pound
Canadian dollar
Australian dollar
Japanese Yen
Other currencies have held up much better against the US dollar, like the Thai Bhat and Mexian Peso, but even these are starting to show signs of weakness.
Low interest rates in nearly all developed nations are greatly skewing the investment landscape and I think this is the beginning of a pretty major shift which can continue longer than what seems rational. This means that the US stock market can continue a lot higher, despite already rich valuations. Capital will always seek out what appears to be the best investment opportunities and there’s a flood of it coming into the US right now creating a rising stock market in the face of a slowing global economy. It can be confusing which is why it’s so important to track capital flows instead of merely looking at economic numbers alone.
We’ve seen this story before though…. The depression began in the 1920’s in most of Europe, creating a flood of capital into the US which fueled the roaring 20’s but ultimately ended in a stock market crash and The Great Depression (for the US). We’re nowhere near that right now and I’m not predicting it will happen. It’s just interesting that it’s the same story and so it has the same potential if this continues to extreme levels. It would be a few more years if it did play out.
Dow Jones Industrial Average – 1915 to 1945
The key takeaway is not that the US dollar is rising against other currencies; it’s that it’s rising WITH STOCKS, not Treasury bonds, as it did in the 1920’s and 1990’s. Only time will tell how long and how far this can go but my guess is longer than most think.
I hope everyone has a great Memorial Day weekend!
Nick