March 2000 was a lonely time for pessimists. Stock prices had hit a record high on the Nasdaq. Investor confidence was never stronger. Yet within months the capital markets tanked and the US was heading into a recession. Stocks finally reached rock bottom in spring 2003 before the Second Gulf War. So why this sense of deja-vu?
First, we have the Dow Jones Index almost back to its previous 2000 high, after a three-and-a-half year climb back from oblivion. Secondly, we are seeing a bond yield inversion of a kind last evident in spring 2000 which is often, though not always, an indicator of a recession to come.
Look at this another way: Higher interest rates have smashed the US housing boom this year; US housing and related activity accounts for a quarter of the GDP of the US. Therefore, a US slowdown or most likely a recession is in the bag although US corporate profits currently still reflect the good times. George Soros predicted this ages ago.
Hence, global stock markets are riding high when they should be heading lower, and accountants are playing tricks with profits again, most likely legal ones this time, to flatter profit statements.
Et tu bonds?
But perhaps the bond market has also got it wrong. The bond market, in marked contrast, is forecasting a fall in short-term interest rates to compensate for a US downturn. So far so good, but if a sell-off of US assets, i.e. the US bonds held by foreigners, was to turn into a rush towards the exit would not the Fed have to put rates up sharply to defend the US dollar?
Then bond prices would fall. Indeed, is that not what you would expect from an asset class paying miserable returns like US Treasuries today? Expecting a good return from low-yielding bonds really is contrary to the dictates of commonsense.
So what of other asset classes? As mentioned above global residential property is clearly coming off a very high top. If the economic slowdown gains pace, and interest rates go up, then logic suggests a very sharp revision of property prices to something more in line with long-term historic valuations or lower.
Perhaps rental yields might once again then begin to reflect the true cost of ownership in terms of interest payments. Commercial property would adjust in the same way only more severely as businesses fail while home owners always have to live somewhere.
Hedge fund losses
Hedge funds? Well, the rocket scientists might increasingly look like desperate gamblers on a losing run in a casino. Certainly their alleged ability to handle volatility will be sorely tested, and one hopes that leverage will be used in the right direction. The $6 billion losses at Amaranth Advisors suggest that not every hedge fund will be a winner.
Indeed, if the sense of deja-vu outlined above comes true then investors would be well advised to keep their cash in US dollars. For a recession and an asset-price crunch could reverse the dollar bear market of the 2000s, at least for a period. As if people sell for cash, the value of that cash rises with the new demand.
Precious metals would also gain as a safe haven asset, with high gold prices and high interest rates strange bedfellows as in the past, and gold acting as a currency of last resort in a financial crisis.
Then we will enter a period when global stocks and real estate are undervalued, and the whole investment cycle can begin all over again. Deja-vu? Well have we not seen this all before? And can you really argue that global stocks and real estate are not overvalued now?