Is the US$ overvalued?
Dave Lewis
Of late, I've gotten quite a few question about my views on the US stock market. Most follow the form, "I'd really appreciate your service more if it contained specific forecasts for the Dow Jones." In response I try to explain my belief that the pressures for change are not, in the main, manifesting in the market of corporate valuation but rather in the media of exchange itself. Stealing a page from Milton Friedman, I think the world is suffering through a bout of "sticky equity indices", which will tend to favor policy choices which force economic pressures elsewhere. This is not to argue that equity prices won't decline but rather that, as a trader, there are better vehicles through which to profit from the coming changes. Joseph Schumpter, in reference to the 30s depression famously said, People, for the most part, stood their ground firmly. But that ground itself was about to give way. That ground, in the current environment, is the value of the media of exchange, the US$.

Value, in an objective sense, is one of those terms that is oft used without context and thus, in my view, incorrectly. For example, I often read opinions suggesting that US stocks are inherently under or over valued. While this notion might, recalling previous discussions of cognitive dissonance, increase one's sense of comfort with a prior or future decision, it conveys little meaning. One can, alternatively, argue that an equity security is overvalued measured in terms of, say, price to sales or price to earnings, relative to historic norms. As noted above, while I believe that the US equity market, in the aggregate, is overvalued relative to those aforementioned metrics, there are other ways to relieve that overvaluation than a decline in the indices.


*source US BEA, World Bank

These other ways involve changes in the value of the media of exchange, a policy option which became available via the adoption of elastic money. In general there are two avenues to take, changes in the relative value of the US$ within the FX markets or a wholesale decline of that system vs. goods, most easily quantified by the US$ price of Gold. The 1985-1987 US$ adjustment which flowed from the Plaza Accord was, in the main, an even adjustment with the US$'s value declining by roughly 50% both vis-à-vis its major trading partners and vs. Gold. Currently, it seems to me that policy makers would prefer an adjustment within the exchange rate system itself, as suggested by recent talk about China's need to float the Yuan. Whether this is possible remains to be seen.

Let's turn now to the supposed overvaluation of the US$. As noted, for valuation to be a useful notion, it must be discussed in context. One normal metric by which to measure to measure currency over or under valuation is via the current account balance. In crude terms, current account surpluses suggest under valuation while deficits suggest over valuation. Thus the rather large, at 4.77% of GDP in Q1 2003, US current account deficit suggests that the US$ is significantly over valued.

Today's charts aim to depict that overvaluation relative to the past. The second chart, updated to include the just released Q1 data and revisions, show that the deficit, in terms of GDP, far exceeds the last extremes seen in 1987. It is worth noting that the normal lag between changes in US$ value and the current account is about 18-24 months. Given that the current decline in the US$ began about 12 months ago, and has been far less dramatic than the decline from 1985, presuming past linkages hold, the current account deficit may well continue expanding for some time.

The first chart aims to relate the US current account deficit to world trade to give a sense of the degree of global adjustment required. As Stephen Roach at Morgan Stanley is wont to argue, while the US makes up roughly one third of global GDP, it has contributed roughly half of world growth of late. In crude terms then, the US borrows 2.5% of the rest of the world's GDP annually. The last significant global current account readjustment was that which followed the Asian crisis. As most readers will recall, this adjustment, orders of magnitude less than a shift to a US surplus, caused significant disruption around the world. Thus the conundrum for policy makers, how to stay in power while cleaning up the mess left over from the 90s boom.

With global stock markets recovering of late and talk of economic rebounds making the rounds, it might seem a bit strange to be speaking of necessary adjustments. Yet, in my view, policy makers are behind the curve. The US external imbalance which begs resolution is substantially larger in terms of both US and world GDP than previous extremes. Presuming that normal linkages are still operant, resolving the current account imbalance will require a larger US$ adjustment than that which occurred from 1985-1987. This is to argue that the resolution process is still in its infancy. Stay short the US$ and long Gold. Attempts to reinvigorate the "strong US$ policy" will only exacerbate current tensions.


Dave Lewis
www.chaos-onomics.com
dave.lewis@chaos-onomics.com

June 20, 2003