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Foreign Flows Into US Set to Shift

Hey There Income Hunter,

 

The greatest advancement in the 100-year cycle of the Federal Reserve has been the development of the financial markets.

 

That development and ensuing accessibility to foreign capital, along with Fed and US government policies, have successfully pulled trillions of foreign capital into the US stock and bond markets.

 

Of course, that capital from abroad is now contributing to the massive financial market bubble the Fed is trying to protect today.

 

Think about this stat …

 

US stock market capitalization represents 61% of global stock market cap … However, the US accounts for only 23% of global GDP.

 

This means the US is more reliant on consumer spending and external financing than most developed countries.

 

Today, I want to show why this is so important to understand and the ultimate ramifications of this trend on your wealth.

 

Extreme Valuation Thanks to Foreign Buying

 

The chart below shows the Wilshire 5000 (the benchmark market cap index) to GDP ratio. Notice how far above the dot-com bubble era we are today …

 

 

This is an all-time high … and if the stock market drops by 25% that means the gross domestic product would fall by 50%!

 

Most investors don’t realize the fragility of a market that is stretched as what we have on our hands today.… And don’t think this has to do with US companies selling more products abroad, because that is not the case. 

 

The extreme valuation is mostly due to higher valuations of corporate earnings or the price-to-earnings ratio (PE). 

 

Massive Equities Overvaluation Drivers

 

      • Interest Rates: As you can see from the chart below, Treasury yields (Red) are tightly and inversely correlated to the cyclically adjusted P/E ratio.

 

Lower interest rates allow equity valuations to go higher, and the situation also creates incentive for investors to own excessive stock exposure.

 

This is because low interest rates make it easier for stock returns to beat the safer investment into Treasury bonds. 

 

So, as we are beginning to see higher interest rates have a negative impact on equity prices, especially large cap growth stocks that rely on low interest rates to fuel their growth.  

 

      • Trade Deficits: This is a really important variable to understand because it is a trigger that will drive mass selling of financial assets in the US as rates rise.

 

Trade deficits always grow for countries that manage the global reserve currency  … 

 

This is because of the deal the US struck with Saudi Arabia in the 1970s, when they committed to protecting OPEC nations militarily in return for their promise to exclusively use dollars in exchange for oil.

 

Five decades later the cumulative US trade deficit has hit $14 trillion dollars!

 

Our deficits are surplus dollars for nations including Japan, Germany, Switzerland, Taiwan and China, among others. Those countries take their excess dollars and invest in US assets like corporate bonds, stocks and real estate.

 

 

Non-US holdings prior to the “PetroDollar” deal with Saudi Arabia stood at 4.3% … Then from the 70s to 2021 the level rose to 25%.

 

The shift in non-US investment into the US has taken the US from the world's largest creditor nation to the world’s largest debtor nation. 

 

 

To be clear about what the chart above represents:

 

The US owns $34 trillion in total foreign assets, while foreigners own $50 trillion in total US assets. 

 

The foreigners pick and choose the best assets to buy and in return the US buys depreciating consumer products from our trading partners so they have more dollars to use in exchange for oil.

 

      • Passive Investing: Fund flows into passive index investments are now greater than flows into active products.

 

Most retirement plans just pour money each and every week into the S&P 500 and other benchmark indexes that are traded closely to the S&P 500.

 

Since most passive indexes are weighted by market capitalization, it means that more and more capital flows into the largest and most expensive companies.

 

The chart below shows how extreme this shift to passive funds has changed the makeup of household portfolios …

 

 

Capital has been flowing into the US at a high rate as massive dollars have been printed and found their way into US financial markets. 

 

The point here is, now that the Fed and US government are being forced to shut off the printing press, where will the buyers come from to hold valuations at such extremes?

 

Bring It Home

 

Later in the week I will lay out possible drivers of the reversal in equity prices.

 

For now the dollar is the critical signpost for when we can expect a serious downturn.

 

I foresee a bounce in the dollar, which may be a great selling opportunity. The dollar itself will be the clue that foreigners are liquidating dollars as they shift to the alternative currencies of non-US trading partners.

 

The winds of change are beginning to blow and once they start to howl we need to be ready to get ahead of the market because the fire sale of assets can spread quickly.

 

Until then …

 

Live and Trade With Passion My Friend,

Griff

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