"The overall assessment of the economic situation is extremely positive," says Alfred Tacke, a German economics ministry official as he prepares for the meeting Sunday-Tuesday of the leaders of the G-8 nations in France.
Perhaps the rise of the euro and the prospect of a summit in the Alps is giving the European finance men vertigo. We're on "top of the world," they cry, like James Cagney in the movie that ends with him on top of a gas cylinder that's about to go up.
But the explosion upward of the euro reflects little on Europe and much more an implosion elsewhere. The question is, How far implosion will go? The U.S. economic miracle of the late 1990s, which kept all aspects of the economy giddily high up in the clouds, is still in the process of collapsing. Stocks, which drove the whole thing, began to fall in the first quarter of 2000; economic growth began to go at the end of that year; the dollar a year ago.
And what are the prospects now? They are that all three will continue to shrivel. The outlook for the U.S. economy and U.S. assets is grim.
The last element of the miracle economy to fall apart, the dollar, is the central driver of the markets at the moment. In recent months it has lost ground at a remarkable rate. At the beginning of December 2002 the euro was worth a little less than $1. As we write we see the euro quoted at $1.19. So rapid a move begs the question of whether a sharp reversal might be possible. Markets do not normally move in one direction unremittingly. One foreign exchange letter that we see has been calling for a dollar rally repeatedly -- and utterly wrongly -- for months. For our own part, we would be surprised to see it happen now.
The reason for the dollar's weakness is that there is no longer enough capital flowing into the United States to offset a deficit on current account that the stimulatory policies of Federal Reserve Chairman Alan Greenspan and President George W. Bush have pushed up and up. The result can be simplified to this: lots of dollars heading into the international market buying imported things -- which Americans like doing -- and not enough foreigners picking them up to put them into U.S. stocks and bonds and property and the like -- because they do not like the United States any more; not, at least, as a haven for their money.
And they are not being unreasonable. Which of our American readers would care at this point to pour a few thousand, or a few hundred thousand or a few million dollars into U.S. stocks? In our view, it would only be an ill-informed one. Now looks a singularly bad time to buy.
Look at the market. The Dow has had three spells in the last 12 months below the 8,000 level -- a benchmark which it appeared to leave well behind five years ago, in the explosive year of 1998. But since mid-March, with the exception of one trading day (March 31) the Dow has stayed above 8,000 and closed Friday at 8,601.
The market's stability has been remarkable. The Chicago Board Options Exchange volatility index, the VIX, closed Friday at 21.4, less than a point above its 52-week low of 20.6. It has peaked in the past year well above the 50 level. What a low reading on the VIX tends to indicate is complacency among investors. They are discounting their fears and not worrying about a fall. It is usually at just such a point that a fall begins.
The waning dollar ought to be setting alarm bells ringing. As the dollar weakens it becomes far less likely that foreign investors will want to put their money into U.S. assets. That threatens the U.S. stock market and the bond market. It means too that the U.S. fiscal deficit will be more difficult to finance for foreigners ought to be, if they are of sound mind, less keen to invest in Treasury bonds, which are paying pitifully low interest rates.
For the stock market what makes matters worse are exceedingly high stock valuations. The New York Federal Reserve Bank puts the average price earnings ratio on S&P 500 stocks at 33.7 as of May 14. That is about twice the historical average and about twice the average valuation in 1995 when the U.S. market was beginning its bull run.
So what do we expect? A negative signal for the dollar is that its sharp fall of April and May has occurred despite some good weeks for the U.S. stock market. The dollar seems set to lose still more ground if the stock market weakens; and its fall will itself be one of the factors undermining the market. A euro worth $1.25 seems likely before July is out.
U.S. stocks we see falling during the summer -- a continuation of the implosion from the bubble's heights. Our belief is that the level we mentioned earlier, somewhat below the 8,000 mark for the Dow, will again be tested in the summer and be broken sometime this year, with the Dow heading below 7,000.
The economic news and the weakening dollar will assail the market. And too many stocks are, despite three years of bear market, far too highly valued, setting or testing all-time highs. About which, more next week.
(Market Eye is a weekly column that will offer an economist's views of the markets. It will normally appear on Mondays. Ian Campbell may hold some of the securities mentioned in his articles. Comments to firstname.lastname@example.org.)
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