Alternating Influences of World Capital Flows Upon Domestic Market Movements
© Martin A. Armstrong
Immediately following the Crash of 1987 we warned that our computer models were showing that the entire affair was nothing but a wild short-term correction, similar to that of 1924. We stated in our reports, as well as in numerous seminars throughout the years, that the Dow would make new record highs by 1989 and continue thereafter going into 1994 or as late as 1996 where a major high would be established. The first portion of that forecast has come to pass and now, as we approach our first target year of 1994, some concern is certainly warranted. Although our models warn that a continued rally into early 1994 will be met with another mini-crash, the key to how the stock market responds lies not merely in its relationship to domestic issues of interest rates, inflation and the latest unemployment statistic, but also in its relationship to the world foreign exchange markets.
While many believe that the current rally in the US share market has been purely driven by low inflation and interest rates, this view is nothing more than a typical understatement of the situation from an isolationist view. The real driving force behind all markets is a much more complicated matrix of interrelationships within the total global capital market structure. If everything were as simple as buying stocks because interest rates are low, then why is it so difficult to predict a crash or forecast tomorrow’s closing price?
Throughout the course of this recent rally the predominant driving force has been none other than the foreign institutional in vestment capital inflows. During the early stages of most big rallies in history, it has always been the foreign buying that drives any market upwards. Domestic buying tends to come into play ONLY after a major move has already unfolded. Our study of this domestic versus international investment force has not been limited to the United States. In our public seminars held in Tokyo during December 1992, we correctly forecast that the Nikkei would decline into Feb/March ’93 and then stage a strong rally going into the spring. We further stated that the rally would be caused by a rise in the yen that would in turn prompt foreign overseas investment in the Japanese stock market. That forecast was viewed to be rather bold since it not merely foretold of a strong rally for the Nikkei and yen, but it also identified WHO would be the buyer as well as WHEN! That forecast was so unusual it was written up on January 7th, 1993 in the Nikkei Shinbum (Japanese Economic Journal) (Figure #1) with the headline stating that foreign buying will come in during March to spark a new rally.
Foreign investment has historically tended to buy the bottoms of all markets worldwide while domestic buying becomes dominant primarily at the tops. This holds true during reactionary moves that are accompanied by a corresponding change in trend for the underlying currency. This shift between international to domestic buying activity has usually been driven largely, but not entirely, by swings in the underlying currency. Our investigations into this phenomenon stretch back into the past two centuries and at no time have we found an exception to this rule.
In the case of our December 1992 forecast for Japan, if we review the interlinked movements of the yen and Nikkei for the period of Feb/Mar ’93 forward, we can see clearly how that forecast was correct in time, direction and participants. Figure #2 provides weekly charts for the yen and Nikkei. The yen reached a bottom against the dollar during the week of February 8th, 1993 and staged an abrupt immediate rally consolidating its gains going into early March. The Nikkei began to rally sharply following the initial upward move in the yen starting the week of March 8th. The lag time between the currency move and the domes tic market in question is never a fixed length in time. Typically, the domestic market will surge on foreign buying once the overseas investors take a positive view on the currency itself. In this case, the lag time was only about 1 month. Given a bullish outlook for the currency, as long as the same view of the domestic market is maintained, then the foreign buyers will enter the marketplace.
The rally in the yen continued into the week of August 16th. The peak in the Nikkei rally came the week of August 30th. As the foreign buyers become concerned about a change in direction for the currency, that concern then broadens toward investments in the domestic market. In this instance, the yen peaked, which sparked concern among the foreign investors causing the high in the Nikkei to form shortly thereafter. As a result, domestic buyers come into the market ONLY after the rally has matured – thereby raising the local confidence levels. Domestic buyers tend to focus largely on political issues, economic statistics, interest rates and various local statements of one sort or another. Foreign buyers are largely removed from the micro- analysis and tend to focus more on international considerations – particularly currency. In part, negative local news in on e nation may be overshadowed by much greater negative news in other nations around the world, which strangely translates into bullishness from the overseas perspective. Much of the more recent strength in North American markets along with Australia has been due in part to the fears concerning Russia. As a result, the dollar tended to strengthen against the European block of currencies giving a fundamental underlying support to all dollar based assets, including stocks. Domestic buyers are led to believe that the market might be overvalued based on local considerations. However, a market may rise well beyond local expectations purely as a safe-haven for incoming overseas capital concerned about geopolitical events or a weakness in their own currency.
If we look at the United States, domestic activity has indeed been increasing in recent months. Many local analysts have cited low interest rates, the CPI or Clinton’s policies. Again, such prognostications have ignored the international capital flows. In fact, rising domestic bullishness may prove to be a warning sign that the rally could stall out or at least a temporary top is close at hand. Figure #3 illustrates the international versus domestic influences in reference to the recent bullish US trend. Here we can easily see that the week of October 5th was a major turning point in 1992. This week provided the secondary high for most European currencies against the dollar. This same precise week also marked the beginning of the breakout rally for the Dow. If you compare the two charts offered in Figure #3, you will notice that even the minor savings in the Dow on a week by week basis are closely tied to changes in direction for the underlying currency. Since 1971, the overall volatility in the currency markets has been steadily rising. Today, the dollar is, on average, making 30% swings every 2-3 years. This generally translates into a far greater risk for international investors than the Dow itself. It does not matter to someone in the UK if the Dow rises 50% if the dollar declines by 60% simultaneously. The foreign investor will lose money while domestic buyers make money.
If we look at the Dow Jones Industrials during the period of 1985-1987, we can see that this index declined going into September 1985 reaching the 1283.7 level intraday. This is the month during which the famous G-5 began. G-5 was a term coined to represent the “Group of 5” nations banning together to manipulate the world economy. It was agreed that a coordinated effort between the top 5 central banks would be established to bring about a decline in the US dollar. This manipulation was undertaken to “supposedly” reduce the trade deficit of the United States by lowering the value of the dollar, which in turn should result in US products becoming cheaper overseas when expressed in foreign currency.
The interrelationship of any domestic stock market to the underlying currency value of that nation on world markets is not always a perfect one. At times during sudden declines in a nation’s currency, the stock market has risen in direct proportion to the decline in the underlying value of t he currency. Such counter-trends are actually quite common and represent a period where the assets of a nation actually “inflate” in value in an attempt to seek parity in international purchasing terms. Such counter-trends are typically marked by heavy domestic buying rather than overseas investment. Nevertheless, such counter-trending periods MUST be accompanied by an underlying economic growth rate in excess of 2% which translates into a reasonable growth trend in corporate profits and consumer confidence. Such a period existed in the United States between 1985 and 1987. The rise in the US share market was in direct proportion to the decline in the value of the dollar. However, confidence remained high along with underlying economic growth.
The Blue-Chip vs Broad Market
Another key indicator that differentiates foreign from international buying trends is none other than the broad verses blue chip indexes. Domestic buyers are made up of local institutions as well as small individual investors. Due to this diversity, heavy buying during domestic bullish periods tends to lead to a broad market rally which often outperforms the Blue -Chips going into the final high. Overseas investors tend to stay away from small-cap stocks and turn their focus toward the more narrow Blue-Chips. Therefore, when the Blue-Chips lead a rally as the broad market trails behind, you will find a strong overseas influence within your domestic market. When the broader market begins to outperform the Blue-Chips, you are nearing a high. It would also be wise to look at the currency in during this period. For if the currency begins to decline on world markets, foreign investors will become sellers thereby cementing the final high.
If we look more closely at the overall bullish trend in the US market through the eyes of the Dow Jones Industrials since the 1982 low, we can easily see a very nice upward trend with a few wild correction here and there. Figure #6 offers a quarterly chart of the Dow since 1963 upon which we have drawn the leading broad-trending channel. Table #1 offers the precise mathematical calculations for this channel projecting out into the end of 1996. We can see that support for the Dow lies in the 3072.4-3133.1 area for the next 6 months. This warns that the Dow could decline 20% and still survive to go on eventually establishing new record highs.
The initial target resistance for the next 6 month period stands at the 3813.1-3873.8 level. Since the Dow has already reached the 3708 level in October , we are still slightly below the initial resistance. Even if the Dow were to rally going into Feb/Mar ’94 reaching just below the 3900 level, it is doubtful that such a high would prove to be anything other than a temporary top. The risk that 1994 would produce the final high for this decade would only tend to come about if we were to see a high in Feb/Ma r ’94 reach the 4263.6- 4324.2 area.
Table #1 Dow Jones Industrials Quarterly Technical Targets 10/93…. 3072.4 3813.1 4263.6 01/94…. 3133.1 3873.8 4324.2 04/94…. 3193.8 3934.4 4384.9 07/94…. 3254.4 3995.1 4445.6 10/94…. 3315.1 4055.8 4506.3 01/95…. 3375.8 4116.4 4567.0 04/95…. 3436.4 4177.1 4627.6 07/95…. 3497.1 4237.8 4688.3 10/95…. 3557.8 4298.5 4749.0 01/96…. 3618.5 4359.2 4809.6 04/96…. 3679.2 4419.8 4870.3 07/96…. 3739.8 4480.5 4931.0 10/96…. 3800.5 4541.2 4991.7
There is littel doubt that a serious risk of a mini-panic in early 1994 does exist under certain circumstances. Largely, a sharp decline is possible if the Dow continues to rally going into Feb/Mar of 1994 without correcting in the 4-7% range during the 4th quarter ’93. This risk will be present even if the rally stops shy of the 4000 area.
The preferred pattern that we would like to see calls for a Nov ’93 high followed by a Feb/Mar ’94 low. This would then shift this market into a very strong bullish phase for most of next year. If we see a continued rally with the Dow exceeding the 4000 area going into Feb/Mar ’94, then caution should be the battle cry of the day. An early high in 1994 warns that a more serious correction of up to 23% is possible next year. This would still not preclude this market from rising going into 1996 reaching nearly 6000, but it will NOT be an easy rally in the least. A 1996 high appears to be interlinked with a sharp decline in Europe and the value of its individual curencies. Our computer models point to a major capital outflow from Europe to the United States between 1994 and 1998. We suspect that this will be caused in part by geopolitical concerns linked or caused by a Russian Revolution.
Over the past 7 years, we have also warned that the Dow would approach the 4000 level as we came into 1994. The high so far seen in October has been 3708.8. Overall, we expect that if the US share market continues to move higher going into Feb/Mar ’94, then we will see another mini-Crash that could take the Dow down as much as 20-23% over the course of the following 3 to 6 month period. However, even this type of sharp decline may yet be followed by another rally into the final high for 1996 or as late as 1998. This will be our forecast as long as the Dow holds ABOVE all Major Monthly Bearish Reversals during the correction phase. Using our hypothecical models predicated on a Feb/Mar high around the 39188-41451 area, our computer models project the major support during any crash to be between 31199 and 31846 with an optimum target of 31418.