Evidence of Fueling of the 2000 New Economy
Bubble by Foreign Capital Inflow:
Implications for the Future of the US
Economy and its Stock Market *
Didier Sornette and Wei-Xing Zhou
First, let us give a word on the mathematical analysis of herding behavior, bubbles, crashes and anti-bubbles. In previous analyses of a large ensemble of stock markets, we have documented a specific mathematical signature of herding behavior in the prices leading to speculative bubbles that often land with a crash. This signature has been called a log-periodic power law (LPPL), . In this study, we have detected such a LPPL signature in the foreign capital inflow during the bubble on the US markets culminating in March 2000. We have also detected a weak synchronization and lag with the NASDAQ 100 LPPL pattern. Our analysis suggests that foreign capital inflow have been following and amplifying the bubble rather than causing the bubble per se. We rationalize these observations by the existence of positive feedback loops between market-appreciation / increased-spending / increased-deficit-of-balance-of-payment / larger-foreign-surplus / increased-foreign-capital-inflows and so on.
In the sequel, we expand on this mathematical analysis (mathematical, behavioral and macro-economic) and attempt to delineate some implications for the following years. In particular, we ask the question: are macro-economic fluxes and their interplay in accordance with our more technical forecast of a significant correction on the US stock market in the coming year? (these forecasts are available at http://www.ess.ucla.edu/faculty/sornette/prediction/index.asp#prediction)
(Stock market) Implications for the following years
Let us examine the implications of our findings and reasoning for the next
years.
Two main variables have changed since 2000, when compared with the situation in the late 1990s addressed above.
First, the stock markets have declined substantially since their all-time highs in the first quarter of 2000. The NASDAQ composite has lost close to 75% of its value at its dip in October 2002, and remains at a loss of close to 70% at the time of writing. The S&P500 has lost about 47% at its dip in October 2002 and remains negative by about 35%. The Dow Jones Industrial Average lost about 38% at its minimum in October 2002 and remains off by about 23%. The wealth effect has thus vanished.
Second, the Federal budget surplus of the last years of the 1990s has trans-formed again into a growing deficit. The private sector spending fury has abated but the private disposable income over expenditure remains in deficit and several percent of GDP below its long term average. A radical change of attitude to budget deficits has also occurred, which suddenly became respectable as a way to fight fears of recession. In addition, after 911, private spending of households were encouraged at the highest level of the executive hierarchy as being patriotic.
Our own analysis for the period from 2000 to 2002 strongly suggest that the US stock markets has declined as a consequence of another herding process characteristic of bearish "anti-bubbles".
The overheating of the speculative bubble led to a crash on the NASDAQ in March-April 2000. As a consequence of vanishing of the wealth effect and of the self-reinforcing negative sentiments, the stock markets have gone down. As a result of the increasing Federal budget deficit, foreign capital have flowed again to buy the debts issued by the treasury, disrupting a part of the flow that was previously directed to the stock markets. Our analysis shows that the crash on the foreign capital in-flow coincide with the transition from surplus to deficit in the Federal budget.
There are several drastically different scenarios, proposed by various analysts and commentators, for the future evolution of the stock market and of the economy. Standard measures of valuations suggest that the market has not yet bottomed as it still appears significantly over-valued; currently, the price- to-earnings ratio is over 34, the dividend yield is 1.74%, and the price-to-book value is over three times. Compare this to the bottom in 1982, for which the price-to-earnings ratio of the S&P 500 was 7, the dividend yield was 6.3%, and the index was selling at book value.
However, strong forces are willing to push up the confidence of investors, to foster the economy and by the same token the stock market, since the later is a confidence/sentiment thermometer. A first force is the increase in money supply. Since early 2001, the money supply M1, which is basically cash and checking accounts, has been rising at a 30% annual rate, with a deceleration in 2002 and then resuming an acceleration in the first part of 2003. The size and growth of money supply is influenced (controlled?) by the Federal Reserve System through its direct control over the reserves of member banks, the discount rate and through open market operations. This increasing money supply, which is supposed to foster economic development, also finds its way in the stock market, because companies are not spending the money to boost capacity, as some industries like semiconductors are working at only 65% capacity utilization, and the overall capacity utilization rates are around 75% (compared to +90% in the late 1990s). Companies are also using this cheap money to re-leverage their balance sheets, similar to consumers switching their credit card debts to different cards with lower rates.
A second force is found in the behavior of foreign capital inflows. With the growing availability of treasury debts, the enormous surplus of foreign central banks have found again a natural depository. In this way, foreign central banks avoids the risk of inflating their own currency. However, the interests paid have now plummeted from above 6% to 1% per year. The bonds can now be attractive only on the basis of a speculative capital appreciation, no more by the paid interests. Therefore, naturally, foreign capital is attracted to the US stock markets. And here comes into play a confidence and herding game. Notwithstanding the stock market over-value, foreign capital (as well as national investors) would like to see the stock market re-appreciate since they have not many other choices to invest their surplus dollars. There is thus a growing availability of capital to hold prices from falling, at least for a while.
This may constitute a part of the explanation for the appreciation of the US
stock market since the uncertainties with the war with Iraq in March 2003
faded out. Will this continue? At this stage, since we view investors
confidence and herding as an important and integral part of the self-organization of stock markets and of the economy, it is interesting to dwell more on quantitative measures of confidence. So-called market sentiment ratings are obtained through polls where responses are bullish, bearish or neutral on the market, which are regularly available. During the entire time when the NASDAQ 100 dropped by more than 75% since March 2000, there was not one weekly reading showing more bears than bulls. It took the greatest terrorist act in U.S. history to finally register a week during which there were more bears than bulls, for the first time in 153 weeks. The plurality of bears over bulls was minuscule considering the magnitude of the events. The 911 catastrophe could only produce three consecutive weeks where bears outnumbered bulls, after which the bulls dominated the sentiment readings again. The study reported in Barron's study on May 5th, 2003 gave the following categories and responses: Very Bullish (9%); Bullish (51.1%); Neutral (28.6%); Bearish (10.5%); and Very Bearish (0.8%). This is not the type of sentiment (60.1% bulls versus 11.3% bears) after three years of a nasty bear market! This overwhelming reading, already impressive in a bull market, is unheard of for a bear market.
Our reading of this surprising pervasive bullish sentiment is that it confirms
that the private and foreign investors want the market to go up, but that
there is so much uncertainty that "wishing" is different from "acting," that
is, investing. Investors are waiting for signs of confirmation of their bullish
sentiment to drive the price up. They have already been burned severely by the crash in 2000 and the two years that followed. In particular, foreign investors have strong incentive to buy the US stock market as well as corporate bonds and the debts in US real estate market in order to get a return on their surplus dollars above the ridiculous discount rate offered on treasury bonds. But such action would be warranted only if the market risk is not too high, hence the conflicted observations of a strong bullish sentiment in a depreciating stock market. The contradictory conclusions on the economic outlook and these polls suggest that the natural herding behavior of investors will be even more predominant in the future and lead to highly volatile and unstable market behavior in the near future.
As the US stock market and economy were heating up in the late 1990s,
the higher interest rates and stronger dollar were the natural instruments to attempt to avoid inflation and to try to stabilize growth but also resulted
from the economic and stock market growth [61]. Actually, as we explained
above, both led to the rather perverse effect of fueling further the bubble by (1) increasing the deficit of the balance of payment through the deterioration of competitiveness accompanying a strong dollar and (2) by the attractiveness of investing in the US for foreign capital in part obtained through the surplus of foreign countries on their balance of payment.
Now, the situation is different. The economy has been flirting with stagnation and depression several times in the last two years and the stock markets have been falling down; hence, the massive cuts in interest rates. Since May 2002, the strong dollar has been steadily losing ground against the major currencies, with an acceleration of this loss since November 2002, showing a cumulative loss of about 28%. As a consequence, investments in the US by foreigners is becoming less attractive due to the increasing exchange risk and the lowest interest payment.
Weighting these different ingredients, our preferred scenario for the future is the following.
- The private sector will continue spending more than its long-term average,
as it is psychologically difficult to abandon habit acquired in good times
(the glorious 1990s) and it is in addition almost considered as a patriotic
act.
- The debt of the Federal Government as well as the private, municipal,
corporate and local government debts will continue to rise, reinforcing further the US as the major deficit nation.
- As a consequence, interests will remain low to allow servicing of the payment of the interests of the debts, both of private sector and the government. This will continue to have the effect of further fueling the growth of liquidity by the mechanism of fostering loans refinancing on lower interest rates (mostly from residential real estate) This consequence will also continue to be a source of the two first bullets, acting as a positive feedback loop. The central bank of the US is now compelled to peg short-term interest rates, promise to forewarn the marketplace of any intention to adjust the peg. and to guarantee continuous marketplace liquidity. Federal Reserve operations may continue to work by aggressively manipulating rates, yield spreads (by repurchasing long-term debts) and, increasingly, market perceptions to ensure these goals. This is further reinforced by the perception that the proposed tax cuts and current low interest rate environment will further increase liquidity and turn the US economy around which will power the stock market even further ahead.
- The dollar will continue its descent as a mechanism to fight against the
deficit of the current balance by boosting exports (which translate into
cheaper imports for foreigners). A decrease of the dollar also provides a
mechanical device to decrease the absolute value of the debt. This will
accentuate the incentive for foreign central banks to sell progressively their
dollars, but they cannot do it too fast to avoid losing the competitiveness
of their currencies. There is thus a subtle balance between the economic
competition giving rise to surplus in dollars, the corresponding importance
of not having a strong currency and the present lack of attractiveness of
the dollar. We thus envision a slow sell out of the US dollar, but only on
a limited scale since the world is over-flowed by dollars, which has replaced
gold at the international reserve currency, since the breakdown of Bretton
Woods (about 80% of the world's free capital is invested in dollars, even
though the US makes up only about 30% of the world's economy).
- In view of these negative factors, foreign capital will be less attracted to the stock market.
From the point of view of detecting large scale cooperative behavior, our technical paper has constructed a long term view of the evolution of the US market proxied by the DJIA and its extrapolation in the past. Our analysis
suggests that one may wait for at least a year or two before the stock market recovers its long-term trend. This appears to be in line with the prediction that the US stock market will bottom during or at the end of the first semester of 2004, according to our previous analysis of the LPPL anti-bubble which started in 2000.
Our technical analysis shows that the current bear market has been almost as severe as all other bear markets since 1950 but far less severe than the 1932 bear market. One scenario is that the market may have in fact bottomed out in October of 2002. However, if this is a deflationary bear market as the US was in 1932, then a huge decline is still ahead. The interest rate data so far point to a "deflationary" environment but this is far from conclusive as the Federal Reserve is currently waging war with deflation and is probably prepared to drive short term rates to zero to avoid this scenario. But doing so, it is fueling the credit bubble to unprecedented levels, developing another dimension of instability.
A very interesting additional information is provided by the behavior of the main currencies against the US dollar. We have found unmistakable LPPL
signatures of a speculative bubble which is presently developing on the EURO. Specifically, Specifically, the EURO in US$ exhibits a typical accelerating LPPL bubble pattern, which is suggestive of a speculative herding buying of EURO's using US$. Similarly, the EURO in Yen also exhibits a typical accelerating LPPL bubble pattern, leading to a similar conclusion. In contrast, the Yen in US$ does not have any acceleration (nor has the US$ in Yen), even if a marginally significant log-periodicity may be observed. These three analyses provide a remarkable message: the depreciation of the US$ is not just the undirected flight-for- safety of a herd fleeing from a looming catastrophe; it seems to be associated with a speculative bubble directed to what is felt (at least on the short- and medium-term) to be the new haven currency, the EURO.
Conclusion
Our main conclusions are the following.
- The "sacrifice" of the US$ and the stock market is the cost for a lower
sustainable debt burden on the global US debt structure and for allowing the slow rebuilding of an internationally competitive economy. This is reinforced by the evidence for a speculative bubble developing on the EURO. We thus envision a continuation of the depreciation of the US$ that may reach unprecedented low levels.
- On the medium term, the stock market is not going to recover a strong
bullish trend as the growing Federal deficit is consuming a large part of the foreign surplus dollars and the stock market is remaining a very risky and unattractive investment. In addition, the huge credit bubble, that the US has developed in the last decade and is increasingly fueled in the hope "to avoid deflation," may be expected to burst and have severe consequences for the recovery of the economy.
- In the short term, the stock market may hold for a while (on the time scales of a few months, probably no longer) as one of the main sink of a strong surge of liquidity and of the credit bubble, justified in the mind of investors by their sentiment and hopes.
The US has been growing as the major deficit nation in the world, attracting
huge amounts of foreign capital. In parallel, it is also growing steadily by
immigration, powered by a variety of factors. Studying the relationship between immigration and capital flows, Groznik has shown that, surprisingly, labor not only moves in the same direction as capital, but it also leads capital. This finding is also found for various countries, periods and migration flow specifications. Thus, an important predictive variable for international capital flows is immigration flows. One strength of the USA has been its ability to attract people and capital. To what degree this inflow will continue to justify its un-sustainable deficits (at all levels) is linked with its potential for development of new riches and remain to be seen.
(*) The unabridged work may be found at
http://arxiv.org/PS_cache/cond-mat/pdf/0306/0306496.pdf
Feedback to sornette@moho.ess.ucla.edu
19 July 2003
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