Most American investors are probably feeling more than a little down right now.
Since early 2000 the magnificent promises of legendary stock returns running into perpetuity for all have proven to be little more than garden-variety bubble hype. Countless investors' dreams are being mercilessly shattered on the unforgiving steel anvil of fundamental reality. As the post-bubble bust process painfully stretches into years, American mainstream investors are slowly beginning to understand just how vicious and brutal post-bubble bear markets can truly be.
Even though American investors think they've had it bad, European investors in US stocks have fared even worse. European investors have to exchange their euros into dollars before deploying capital in the US equity markets, so in addition to the enormous general US market risk the Europeans also face the unwelcome specter of exchange rate risk.
Exchange rate risk is a sharp double-edged sword. It can significantly enhance gains if the markets cooperate or seriously exacerbate losses if they don't. All international investors have to pay careful attention to the international currency markets. Even in normal market conditions, exchange rate fluctuations can completely wipe out stock market gains for unwary international investors. In fearsome post-bubble bear markets, the stakes are even higher as extreme equity and currency market volatility increase the risk exponentially.
With the much-maligned euro finally achieving parity with the dollar this week for the first time since early 2000, European investors are faced with some very tough decisions regarding any capital they have deployed in US stocks. For every penny higher the euro climbs relative to the US dollar, European investors experience a loss. These losses must then be added on top of any equity losses the European investors have sustained in the US stock markets, and the resulting numbers can be pretty frightening.
Although many stock investors don't even like to think about exchange rates, they are so important to understand. Even American investors need to understand exchange rate risk because the US capital markets are so heavily dependent on foreign investors.
Amazingly, foreign investors were the third largest purchasers of US equities, after only US mutual funds and life insurance companies, between 1997 and June 2000 when the US equity bubbles were festering. If foreign demand for US stocks wanes, the terrifying bear market in the US will grow even worse. Hemorrhaging an enormous source of buyers for US equities would certainly be ugly at a time when selling pressure already dramatically outweighs buying demand.
In addition, foreign investors' capital is desperately needed by the US to finance America's gaping trade deficit. Without foreign investors, American consumers would not be able to finance their mighty debt binge on imported goods. In a very real sense, the whole materialistic American way of life financed by debt is only possible because foreign investors are willing to send capital back to the US financial markets. Without this massive influx of foreign investment, the US dollar would almost certainly plunge and the era of cheap imports for American consumers would gasp its last breath.
Foreign currency exchange rates are extraordinarily important to the US capital markets. All investors in US equities, regardless of their citizenship, need to carefully monitor the state of affairs in the foreign exchange (FOREX) markets to help them discern potential future trends in US equities.
While this essay focuses on the torturous plight of European investors in US equities due to the euro's amazing rally thus far in 2002, the same analysis applies to other foreign investors in the US markets as well. Whenever the US dollar falls relative to an investor's home currency, they face mounting FOREX losses that can wreak havoc on their portfolio's performance.
A simple example can help clarify and quantity FOREX risk.
Imagine that a European investor wishes to invest 100k euros (henceforth E100k) in the US equity markets and plans to deploy her capital in the States for one year. As the year begins, each euro only buys US$0.80 worth of dollars under current exchange rates. Ignoring transaction costs, our European investor purchases US$80k with her E100k and immediately deploys her dollar capital into the US equity markets.
Now fast-forward one year into the future. I know it is a big stretch to imagine US stocks actually falling after a supercycle bubble bursts, but we will assume that the US markets are down 15% over the year the European was invested in US stocks. Our European investor had purchased US$80k worth of stocks when the year began, but with a 15% fall in the US markets she now only has US$68k worth of stocks left. Deciding she has finally borne enough pain in the US, she sells her stocks. To complete her transaction she needs to convert her US dollars back into euros so she can invest them back home.
Unfortunately during the year, however, we will assume the euro actually rose in value. Now instead of each euro buying $0.80 worth of dollars, each euro can buy one whole US dollar, the fabled "parity" level. The euro has risen by 25% during the same year the US stock markets fell by 15%. Our European investor takes her US$68k proceeds from her US stock sale, repatriates it to euros at the going one-to-one rate, and she has E68k of capital left.
With a 15% drop in US equities and a 25% rise in the euro, our European investor had the misfortune of turning her original E100k capital deployment into only E68k after one year, a 32% loss! Losing that kind of money that fast, she ought to work for Wall Street!
Whenever any foreign investor invests in the world's ultimate market, the United States, and their local currency rises relative to the US dollar over their investment timeframe, they will experience FOREX losses. The fluctuating exchange rates are especially painful in a massive bear market as the FOREX insult is heaped on top of the US stocks injury, leading to very substantial losses.
Sadly, the numbers in our example are not far from reality. The euro reached an all-time low of US$0.8262 on October 19th, 2000. At the time, the failing fiat currency was saddled with the popular epithet "zero" as each euro was worth only about 83 cents in US dollar terms. As the euro had been scandalously sinking like a millstone treading water since it was launched in January 1999, it is not hard to imagine many European investors growing discouraged at the seemingly endless series of new euro lows and buying dollars with their euros near the very bottom.
Warping ahead to this week, the embattled euro surged and was trading back over the $1.00 parity level for the first time since early 2000. An enormous rally in the euro has arisen so far in 2002 as the dollar's fall accelerates. European investors in US stocks, in addition to facing the horrific losses in the US bear market in recent years, have also had to deal with the traumatic torture of a sharply rising euro, mushrooming their total losses.
Our graphs this week illustrate what the NASDAQ and S&P 500 look like from a European investor's perspective. We arbitrarily chose a euro/dollar exchange point of the October 2000 low for this essay. While few Europeans probably traded their euros for US dollars at the exact bottom, history certainly proves that the great majority of investors do buy and sell at exactly the wrong time, so this assumption is not too far-fetched. While a different specific starting date for a European US equity investment does change the magnitude of the FOREX losses, it does not alter our core message, that the euro rise is mercilessly torturing European investors in US equities.
The original US equity indices in blue and the indices from a European investor's perspective in red are graphed on the left axes. The euro exchange rate in yellow, the cost of a single euro in US dollar terms, is graphed on the right axes. Even though American mainstream equity investors think they have it bad, the dollar's slide has made the situation even worse for the foreign investors we desperately depend upon to finance our enormous trade deficit.
The spectacular NASDAQ crash has been even harder on foreign investors. A European investor who had the misfortune to buy at the euro low, marked with the white arrow above, is now down 68% compared to 59% for an American investor over the exact same time horizon. The giant rally in the euro in 2002 sparked by the accelerating fall of the US dollar has greatly upped the ante for any European investors who have US investments but have thus far remained indecisive on whether to sell or not.
As I have painstakingly argued in dozens of past
As the dotted-white euro support line above illustrates, the euro is locked in an unmistakable strategic uptrend. How high will it go? While no one knows the answer, I suspect that many European investors are deciding that discretion is the better part of valor and they are selling out of the US markets now and repatriating their capital before the euro runs even higher.
Although today's euro at dollar parity may seem high, there is no reason that it can't march even higher. In January 1999 when the euro was launched, it cost over US$1.18 to buy a single euro. When Greenspan's enormous monetary inflation in the US is coupled with plunging equity markets which lower the global demand for dollars, it seems that the most probable future scenario is for the dollar's slide to continue. The US dollar's strategic trend generally runs in 5 to 7-year cycles, so the current dollar downtrend is probably just getting started.
For every one percent the dollar falls in its quest to correct from its grossly overvalued status during the bubble years when foreign investors scrambled to deploy capital in the US, the euro and other major foreign currencies rise by a similar amount. As long as the US dollar is falling, there is almost no reason for foreign investors to risk more of their scarce capital in the US markets. Even if we weren't mired in the belly of a sadistic supercycle bear market, rising foreign currencies dramatically reduce or eliminate any potential gains to be made in US stocks.
As the same type of graph for the S&P 500 shows, there is an eerily strong inverse correlation between the performance in the flagship US equity index and the euro. As the three yellow arrows indicate, the euro rises (or the dollar falls if thinking from an American perspective) as the S&P 500 drops. This is very strong evidence that foreign investors' aggregate US dollar demand depends on US equity market performance to a great degree. Definitely a very scary omen in a shaky once-in-three-generation bear market that relies tremendously on foreign capital injections!
While American investors see the S&P 500 flirting dangerously with the 900 level after its gargantuan multi-year head-and-shoulders technical formation failed, European investors who happened to buy in near the euro low are shuddering and looking at the equivalent of the abysmal 700 level, an almost 50% loss! That's really gotta sting!
With probabilities vastly in favor of continuing bear market plunges in the US, albeit punctuated with short and spectacular bear market rallies to keep everyone awake, why do foreign investors even bother investing in the US markets right now? In addition, as the bear market continues to evolve and disembowel unwary investors, the US dollar is likely to continue falling. Without the profit incentives to invest in US equities, foreigners will demand fewer dollars. In the global free FOREX markets, if the dollar supply is rising and dollar demand is falling, the dollar's price has to drop.
A vicious circle you wonder? Absolutely! This whole FOREX mess for foreign investors in the US created by the falling dollar has the potential to become a terrible self-fulfilling prophecy.
Riddle me this… The US markets decline. Foreign investors begin to sell US stocks because they are tired of sustaining year after torturous year of huge losses in US equities. The foreign investors then sell their dollars and buy back their local currencies. This creates downward pressure on the dollar as the supply of dollars for sale increases at the same time demand for other currencies, like the euro, increases.
As the dollar continues its downward spiral, the remaining foreign investors in the US watch in horror as their already large losses balloon ever larger. They gradually reach their own pain thresholds and liquidate their US stocks. The stock sales increase stock supply pushing US stock prices even lower and the bear market intensifies. The foreigners then sell their US dollars and repatriate their capital to rising local currencies.
The net effect is a vicious circle that could continue to intensify and feed on itself like a financial hurricane over warm tropical waters. The lower the US markets plunge, the more pressure on the US dollar. The farther the dollar falls, the lower the US markets plunge. This is a very scary scenario for anyone long the US dollar or US equity markets, whether they carry a foreign or American passport.
All investors weary of the relentless torture in the US markets should pull their capital out. Wall Street has lied to you for almost three years in a row telling you everything is fine. It is not. We are languishing through a rare once-in-three generation supercycle bust bear market and we haven't bottomed yet. Unfortunately the pain is not even close to ending.
Speculators can still reap legendary returns shorting the major US equity indices and the US dollar. Both will probably continue to fall until US equity valuations return closer to their historical normal levels as defined by out-of-favor traditional multiples like P/E ratios. Speculators can make money in any market conditions imaginable as long as they ride the primary trend and don't fight it.
Investors face more challenges than speculators, because they only deploy capital on the long side. Going long the general US equity markets is suicidal for any investor on earth until they fall down to fundamental reality and popular sentiment waxes wretched. The time to invest in US equities again will be when they are trading around 7x earnings and the US stock markets are universally loathed and reviled.
In the meantime, foreign investors should evacuate out of dollar-denominated assets with extreme prejudice until the dollar's bearish trend runs its full course. Investing in much cheaper European stock markets in earnings terms is a very attractive option for European investors tired of submitting their aching carcasses to the fiendish torture that the United States' disastrous inflationary monetary policies have imposed on them.
For my fellow Americans, the best way to avoid this sickening ongoing carnage, both in the dollar and US equity markets, is to buy hard assets with real values independent of the plunging US dollar. My favorite, as I have articulated in countless past essays, is gold, the ultimate asset. No, gold does not pay interest, but it will absolutely retain and probably increase its real purchasing power as the US dollar and equity markets continue to fall.
If the US dollar continues to fall by more than a few percent a year, almost a certainty, then cash in US money market funds is actually losing purchasing power in real terms every year. Earning 3% in cash while weathering a 10% dollar fall leads to a 7% real loss, absolutely unacceptable. Physical gold is immune from dollar problems and will thrive in such an environment.
Gold's whole portfolio mission is to preserve capital through exceedingly difficult times such as the ones in which we currently find ourselves sojourning. The goal for all investors is to get your capital out of harm's way, let the unforgiving Great Bear do its thing, and zealously safeguard all your capital to buy the bargains of a lifetime a few years from now when the bubble speculative excesses are finally purged.
European investors deploying capital in the US are very savvy and have experienced far more than their fair share of fiat currency troubles in their lifetimes. As more and more realize that they don't have to bear the relentless torture in US equities and the US dollar, they will repatriate their capital to end their pain.
The US dollar and US equity markets are not going to fare well under this increasing onslaught of foreign investor selling.