An Example of Mania Thinking to Justify the US Stock Market Bubble

Look at the so-called “analysis” below from the following Bloomberg article:

A rising dollar may help push U.S. stocks higher by giving international investors more incentive to buy, according to Michael Shaoul, chief executive officer of Marketfield Asset Management.

The CHART OF THE DAY displays the performance of the Standard & Poor’s 500 Index and the Dollar Index since 1994 in the top panel. The correlation between the gauges, based on the most recent 200 weeks of trading, appears in the bottom panel.

March marked the first time since 2005 that the Dollar Index, which IntercontinentalExchange Inc. uses to track the currency’s value against the currencies of six of the largest U.S. trading partners, had a positive correlation with the S&P 500. Since then, the relationship has grown stronger each week.

“Foreign capital flows are starting to be attracted to the U.S. equity market” in a way last seen when the Internet bubble sent stocks surging in the 1990s, Shaoul wrote. The New York-based analyst added that he expects the dollar and share prices to rise together for the next few months.

One doesn’t need to be an “expert” to note of the bandwagon effect from higher financial market prices. This is not just an example of reflexivity—feedback loop between expectations and outcomes, it is an example of survivorship bias (looking only at the winners) and most importantly it is an example of the incentive to yield chase via momentum trade. People simply love to chase winners or the popular. The same applies to politics.

Here foreign capital flows serve merely as fundamental “rationalization” for the pattern and narrative seeking momentum trade behavior.

Look at the provided chart, while there are periods of extended tight positive correlations, there are also prolonged periods of negative correlations. Importantly, there have been whipsaws such as 1996 or 2002. In short, the correlation trade, between the S&P and the US dollar, has hardly been a sure thing.

Given today’s environment, a higher dollar means a bubble or credit fuelled yield chasing process is in progress. The artificial boom becomes a magnet for international speculators. Thus “foreign capital flows”. The same applies to the Philippines or ASEAN.

It also means that the race to devalue everyone’s currency has temporarily been tilted in favor of the US dollar. The marketplace temporarily expects counterparts of the US dollar to relatively devalue more. For instance Japan’s Abenomics may have made the US dollar as interim shock absorber for capital flight.

The strength of the US dollar also means that given today’s financial globalization, political-economic woes, such as the Eurozone, having been aggravated by the prospects of widening bank deposit seizures, has resulted, not only to reaching for yields for the benefit of the US dollar, but again the US dollar as interim refuge for capital from fears of confiscation.

But what this article fails to cite is the economic aspect: does higher prices lead to more demand or less? What if the booms turn into a bust? What if the FED revs up on the $85 billion a month purchases? What if the hibernating bond vigilantes in the US reawaken? What if for some reason or another, financial markets lose confidence on the US dollar? What if there will be a run on fiat money in general or across the world?

Banking on correlation without understanding the causal process signifies a hazardous undertaking.

The above oversimplified justification of buying stocks by using the US dollar correlation is an example of bubble mentality.

Caveat emptor.