Falling US dollar and surging stocks, like in 1987!

There is an argument for foreign investors to buy US equities at the moment as the US dollar is weak and so they get more stocks for their money. Hence foreign money is fuelling a rally in the US stock market at a time when GDP growth has slowed to 1.4 per cent.

But in euro or sterling terms these investors are not getting a good deal. The 12 per cent devaluation of the US dollar has wiped out most of the stock market gains for foreign investors over the past six months.

The question is surely at what point foreign investors will bail out, and realize that dollar devaluation is wiping out their profits? After all the US economic outlook is not good with the US housing sector in crisis and the consumer increasingly under pressure, so the economic fundamentals are weakening, not getting stronger.

1987 similar

This Day of Reckoning can not be far away, and a sudden reversal of confidence by foreign investors could crash the US stock market for reasons very similar to what happened in 1987: equities riding too high on a cheap dollar.

However, the level of leverage in the capital markets is generally acknowledged to be very much higher than in 1987, beyond even what produced the Wall Street crash of 1929. So the fireworks, when they start, will truly light up the sky.

Leading the leverage boom is the hedge funds followed by the private equity funds. Nobody is exactly sure how much leverage is in the system from the derivative structures erected by these financiers but it is a house of cards that will come crashing down in a stock market correction.

Asset storm

The knock on effect in other asset markets would also be considerable, with commercial and high-end real estate feeling the cold wind of recession howling through the markets.

The immediate policy response would almost certainly be the slashing of interest rates, as seen in the 2000 dot-com crash. This would tend to stabilize confidence but markets do tend to still drift lower - the previous bottom was in spring 2003 - so investors should not ignore the warning signals at this stage.

In a big market upset, what was formerly out of fashion usually does best, and the previous favorites fare worst. That would mean a rally for the US dollar and stabilization of US housing, and bad times for hedge funds, private equity and mutual funds. Bonds would surge on lower rates.